A Question Of Style

Convertible Arbitrage These strategies are created by taking a long position in a convertible bond or a convertible preferred stock, and offsetting this with a short position in the underlying security. The convertible portion will usually mirror movements of the underlying security, but it will also exhibit characteristics of a fixed-income instrument, paying a regular coupon or dividend. When matched in the appropriate ratio, much of the security and market-specific risks associated with the individual investments are eliminated, leaving the coupon or dividend component behind for a virtually risk-free return.

Equity Market Neutral These strategies could be categorized as an equity strategy, but unlike long/short strategies, equity market neutral strategies try to hedge out all market, sector, country, and other exposure. On a regular basis, these funds evaluate their market exposure and, typically using computer driven models, readjust their long and short positions to equilibrium. The result is an equity portfolio with little correlation to the equity markets.

Fixed Income Arbitrage These strategies capitalize on temporary distortions in global fixed income and derivative instruments that are caused by external shocks to the market. Using complex algorithms to determine the correct yield curves and bond prices, fixed income arbitrage fund managers take offsetting positions in related issues to try to create absolute returns with little overall exposure to the market.

Event-Driven Strategies

These strategies focus on specific corporate finance events, such as acquisitions, bankruptcies, and restructurings, and invest in the securities of companies whose prices are determined more by these events than by general movements of the market. While the results of corporate proceedings are not predictable to most, the managers of event-driven funds often have a highly specialized knowledge of corporate finance or law, and take highly concentrated, but predictable, positions in select companies. There are two primary subcategories of this strategy:

Merger Arbitrage These funds typically take a long position in a company that is being acquired and a short position in the acquiring company. These offsetting positions hedge out much of the market and security-specific risk and leave behind the spread between the current pricing and what the prices are expected to be after the corporate finance event.

Distressed Securities These strategies are based on the manager’s ability to pick companies that are undervalued and have a high probability of recovery. In contrast to other strategies, which use offsetting positions to hedge risk, these strategies often take long-biased positions in single securities. Since these securities are often priced well below their intrinsic value due to pending corporate actions, they do not trend based on the direction of the market, and therefore market-specific risk is not a great concern.

Global Macro Strategies

These strategies can be difficult to define, since these funds usually employ variations of all the hedging strategies covered here. Using a macroeconomic top-down approach, the managers of these funds scour the globe for investment ideas and make large, aggressive bets on the direction of the market. Global macro funds invest in everything from stocks, bonds, and commodities to currencies, derivatives, and real estate and utilize all types of strategies from concentrated speculative bets to hedged arbitrage positions. Global macro funds take substantial, unhedged, and often highly leveraged positions, and can expose investors to a significant amount of market risk.