A previous post presented a broad categorization of individual hedge fund strategies:
• Relative value arbitrages
◊ Market neutral funds
◊ Convertible bond arbitrage
◊ Capital structure arbitrage
◊ Merger arbitrage
◊ Distressed situations
◊ Traditional long strategies in hedge fund structure
◊ Short selling funds
◊ Long-short equity (combines directional and relative value approach)
◊ Managed futures / commodity trading advisors
◊ Global macro / global tactical asset allocation
In addition, some hedge funds pursue a combination of these strategies. Multi-strategy funds implement several separate hedge fund strategies within what is a single fund from the point of view of the investor. Whereas, funds of hedge funds (FoF) either diversify among separate managers in a similar strategy (strategy-specific FoF) or separate strategies with different external managers (multi-strategy FoF).
Here are brief descriptions of the individual strategies in further detail. Note that we do not take the above outline in order. Instead, we present the strategies in an order that helps illustrate how the hedge fund takes advantage of the tools made possible (fee structures, margin, derivatives, leverage) to capture returns not normally available in traditional long-only fund form.
Traditional Long-Only Strategies in Hedge Fund Form
While there are many strategies that hedge funds implement that traditional funds cannot, it is worth noting that hedge funds can pursue virtually any investment strategy that a similarly capitalized individual might pursue on their own, including strategies associated with traditional mutual funds. Emerging market equity or illiquid distressed debt, for example, could be operated equally as a hedge fund or as a traditional mutual fund.
Why would a hedge fund pursue a traditional strategy such as long-only equity or debt, instead of organizing under a traditional fund structure? In a word: fees. Traditional mutual funds are prohibited from charging performance fees (fees calculated as a percentage of investment returns). Regulations on traditional funds mean they can only charge management fees based on a percentage of assets under management (AUM).
For the fund manager, the performance fee may make it more profitable to operate off of a smaller AUM and collect a performance fee than to scale up to a mutual fund and charge a management fee only. For strategies that involve illiquid or thinly-traded assets, or those whose performance may degrade if AUM gets too large, this may be a better structure for the fund manager and helps the investor from having the fund grow too quickly and possibly lose its edge because of size and liquidity constraints.
For the investor, it is the after-tax, after-fee performance (preferably risk adjusted) that matters. Although it can be frustrating from the investor's point of view to pay a performance fee for what looks like a traditional mutual-fund type strategy, if the manager is genuinely able to outperform based on skill and the opportunities enabled by having a smaller AUM, the investor may still benefit from the hedge fund structure.
Traditional mutual funds are not allowed to purchase securities with borrowed money. In practice, this also means that traditional funds cannot short sell stocks or other assets, or are constrained in how much they can short sell, and are limited in their ability to profit from overvalued securities. A traditional fund can outperform somewhat by avoiding overvalued securities, but a hedge fund can potentially profit more through a short sale, which sells someone else's (borrowed) stock at a high price and repurchasing it later to return to them at a lower price, pocketing the difference.
Short funds are well suited to the hedge fund structure. Shorting requires posting margin to brokers in case stock prices rise and need to be repurchased at a loss, but traditional mutual funds are extremely limited in their use of margin, and so shorting strategies generally require a hedge fund structure.
An advantage of short funds is that they tend to be negatively correlated to market performance as a whole, and therefore offer diversification benefits to more traditional long-only investments. A skilled manager should still be able to find some shorting opportunities in a bull market, although it is more difficult under those conditions.
The very first hedge funds used market-neutral strategies that essentially balanced the dollar value of long assets (assets bought) and short-sold assets. Later versions improved on the method using statistical balancing strategies made possible through computing advances. The idea was that these portfolios were insulated from broad market movements, because any losses taken on long assets would be offset by gains in short assets, or vice versa.
The performance of market-neutral portfolios thus depended entirely on the ability to select undervalued assets for the long portion and overvalued assets for the short portion. They arguably maximized the value of company knowledge and analysis, while eliminating the often random-seeming effects of the market as a whole. For this reason, market-neutral portfolios should also have low correlation to broad market indexes and therefore provide diversification benefits to a traditional asset allocation.
Market neutral portfolios are most often portfolios of equities, although many assets can be constructed in a market neutral way. Market-neutral constructions in fixed income or other asset classes are often called "relative value arbitrage," which is discussed below.
Equity Long-Short Funds
A long-short fund takes the basic idea of a market-neutral portfolio-balancing long positions and short positions against each other to maximize the ability to capitalize on investment insights-but does not insist that the influence of broad market movements net out to zero. By doing this, a manager can combine insights into asset over/underpricing with a view on how the broad markets are likely to behave. The fund can have a net long or net short bias depending on the manager's mandate and/or view.
A common form of long-short fund is the 130/30 fund, which allocates approximately 30% of AUM to short positions and uses the cash from short sales to place 130% into long positions. What results is a portfolio that permits the manager to benefit from the "juiciest" shorting opportunities to outperform, while still maintaining much of the risk characteristics of a traditional long-only fund.
Relative Value (Fixed Income) and Statistical Arbitrage (Equities)
Relative value funds essentially use either market neutral or long-short approaches on asset classes such as equity, fixed income, and credit. Usually, these strategies use statistical techniques to identify overvalued and undervalued securities, either in pairs or in larger groups. The strategy carefully balances assets considered overvalued against those determined to be undervalued and make a profit if one or both assets converge to their statistically determined fair value.
Convertible bonds are effectively ordinary bonds with an embedded stock option or warrant. To the extent that a convertible bond can be simulated with ordinary bonds, dynamically traded stock, and/or options on the stock, a hedge fund pursuing this strategy can profit when convertible bonds prices do not match the value of the warrant plus the straight bond. This strategy generally requires the ability to short either the company stock or the company bonds in order to eliminate other sources of investment risk.
Capital Structure Arbitrage
Similar to convertible arbitrage, there is a relationship that ties the value of a company's stocks and bonds together; ultimately, the risk of the stock plus the risk of the bonds (and preferred stock, if any) should add up to the risk for the entire company. Returns for stocks and bonds should also add up to the return on the company as a whole. If the market prices of a company's stocks and bonds fail to maintain this relationship, then one security type is overvalued relative to the other. Overvalued stock, for example, should be shorted in order to buy bonds in the same company, and profits will accrue to the extent that the link between stock risk/return and bond risk/return is restored.
Event-driven funds take advantage of special features of corporate or organizational events. The two most common types of event-driven strategies are merger arbitrage (risk arbitrage) and distressed situations. Merger arbitrage takes advantage of the tendency of a purchasing company in a merger to overpay for the acquired company's shares; as a result, the purchaser's valuation will tend to decline and the acquired company's stock will appreciate until they converge on the merger date. Distressed funds take advantage of bankruptcy and corporate turnaround situations to identify mispricings in corporate assets, stocks, and bonds, that, emerge when a company is in or at risk of bankruptcy.
Managed Futures Advisors / Commodity Trading Advisors
Managed futures advisors (sometimes called CTAs) use futures contracts to generate the exposures that drive their strategies. Futures contracts exist for commodities such as gold, oil, and corn, as well as non-commodity financial assets such as interest rates, stock indexes, and currencies.
Advisors traditionally manage portfolios that profit from changes in futures contract prices, and they are often included in portfolios that can afford them in order to provide asset allocation diversification. Over the long term, a diversified portfolio of futures contract returns tends to have low correlations to stock and bond returns, so they are beneficial to have in portfolios as long as they are at least somewhat profitable on their own.
Traditional mutual funds are not permitted to use futures contracts in this way, which is why the hedge fund structure works well. Most advisors use rule-based systematic trend-following techniques to generate their returns, but some use discretionary gut-feel, and counter-trend or other techniques are possible.
Global Macro / Global Tactical Asset Allocation
Global macro is the broadest possible fund mandate, empowering the manager to go anywhere, invest in anything, with any legally permissible instrument. Given that most other managers are locked into a specific asset class or sector, global macro is often able to capture misallocations or mispricings between entire asset classes, currencies, and economies as a whole that other managers either cannot see or are unable to exploit. Although exceptions exist, most macro managers tend to invest in broad asset indexes, currencies, and commodity futures rather focusing on individual company stocks or bonds. They are also free to use derivatives to control speculative risk, lever up opportunities, or take a view on and profit from changes in volatility.
Macro funds can be discretionary, relying on the individual research and judgment of the portfolio manger, or systematic, implementing a set of rules regarding asset classes. When a macro strategy is systematic, it is often called "tactical asset allocation," although some discretionary managers will occasionally use this term too.
While true macro investing is unconstrained, many managers do voluntarily limit their investments to a specific subset of assets, such as emerging markets or commodities, or specific currency or interest rate instruments. Usually, self-constrained macro funds exist to focus fund risk on the type of analysis the manager is best at performing; it can be appropriate for finding the right niche for the fund, because many investors may be looking only for exposure to a specific set of instruments or classes.
There are a wide variety of hedge fund strategies, enabled by the freedom of the hedge fund structure to invest in a wider variety of instruments than traditional mutual funds, and often incentivized by the possibility of collecting a performance fee on positive fund returns.
It is worth noting, however, that the options available to traditional funds are also changing with the investment landscape. Innovations such as inverse ETFs-whose value rises when indexes they are tied to drop-now allow traditional funds to do limited amounts of shorting without breaking rules on margin. The development of active ETFs may mean that some strategies that were previously only executable as hedge funds may now be more feasible in more traditional portfolios.
The strategies themselves are still worth knowing, however, whether they are implemented through the hedge fund structure, or as ETFs, traditional funds, or by attentive individuals, because they all offer possible ways of generating positive returns on capital and further diversifying a portfolio for those willing to do their homework.
Disclosures & Disclaimers
Securities offered through Registered Representatives of Centara Capital Securities, Inc., Member FINRA/SIPC, and Centara Insurance Services. CA Insurance Lic. #0F30702. Investment advisory and financial planning services offered through Centara Capital Management Group, Inc., a Registered Investment Advisor. CA Insurance Lic. #0D85861. Legal services provided by Centara Legal Group, APC, David J. Gebhardt, Principal. None of the information presented is to be construed as investment advice. See a prospectus before investing.
This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results.