Hedge Funds

Hedge funds employ strategies to offer their investors absolute returns (net of fees and taxes). These private funds are actively managed and employ aggressive strategies across asset classes.

Characteristics of Hedge Funds

• Hedge funds invest in many different asset classes, such as equities, fixed income, commodities, futures, credit, and foreign exchange, taking long and short positions and using derivatives.
• The main goal of hedge funds is to generate high returns, either in absolute form or on a risk-adjusted basis relative to their portfolio-level volatilities.
• Hedge funds are structured as private investment partnerships. This only allows a small number of investors to participate in each fund.
• There are restrictions on redemptions. Hedge fund investors may be forced to retain their money in the hedge fund for a stipulated period, known as a lockup period.
• There are concerns over self-reporting and survivorship bias in hedge fund indices. “Survival bias” refers to a database that only contains current investment funds and excludes funds that have failed.

Hedge Fund Strategies

Hedge funds may be classified by strategy, among other classifications. Particular strategy-based classifications include:

1. Equity hedge strategies.
2. Event-driven strategies.
3. Relative value strategies.
4. Macro and commodity trading advisers (CTA) Strategies.

Equity Hedge Strategies

These focus on public equity markets and take long and short positions in equity and equity derivative securities. Equity hedge strategies include the following:

• Market neutral: These strategies use technical and fundamental analysis to identify under and overvalued equity securities.
• Fundamental L/S growth: These strategies use fundamental analysis to identify companies expected to exhibit high growth and capital appreciation.
• Fundamental value: These strategies use fundamental analysis to identify companies deemed undervalued.
• Short-biased: These strategies use technical and fundamental analysis to short, overvalued equity securities.
• Sector-specific: These strategies exploit manager knowledge in a particular sector and use technical and fundamental analysis to identify opportunities.

Event-driven Strategies

Event-driven strategies aim to profit from events that bring change, such as acquisition or restructuring. Examples of event-driven strategies include the following:

• Merger arbitrage: This approach involves going long the acquired company’s stock at a discount to its takeover price and going short the stock of the acquiring company when the merger or acquisition is made public.
• Distressed/Restructuring: These strategies are mainly used on the securities of bankrupt companies or those deemed to be on the verge of bankruptcy.
• Special situations: These strategies are mainly applied to opportunities to get involved in the equity of companies engaged in restructuring activities other than acquisitions, mergers, or bankruptcy.
• Activist (Activist shareholder): Managers who seek to own sufficient equity holdings have a substantial influence on the policies and direction of a company. A fund manager may influence a company’s investment outcomes through this strategy.

Relative Value Strategies

Relative value funds attempt to profit from a pricing difference or a peculiar short-term relationship between related securities. Relative value strategies include:

• Convertible bond arbitrage: This seeks to take advantage of perceived mispricing between a convertible bond and its component parts, such as the embedded stock options.
• General fixed income: These strategies aim at the relative value within the fixed-income markets, emphasizing sovereign debt and the relative pricing of investment-grade corporate debt.
• Fixed income (asset-backed, mortgage-backed, and high-yield): These strategies are aimed at the relative value of higher-yielding securities, including asset-backed securities (ABS), mortgage-backed securities (MBS), and high-yield loans and bonds. Using this strategy, the hedge fund focuses on earning highly secured coupons and taking advantage of the relative mispricing of securities.
• Volatility: These strategies use long or short market volatility options in a specific asset class or across asset classes.
  • A short volatility strategy sells options to earn a premium and benefit from a stable market. However, short volatility can lead to losses during unanticipated market stress.
  • A long volatility strategy is the opposite of a short volatility strategy. The downside of the long volatility is the cost of premiums while hoping for favorable market movements. This method requires numerous methods to rebalance option-based exposures.
• Multi-strategy: Multiple managers using different investment approaches try to find the best investment vehicles.

Macro and CTA Strategies

Macro hedge funds focus on a top-down technique to identify economic trends. Put another way, the basis of trading is the expected movements in economic factors. Macro strategies allow managers to trade opportunistically in fixed-income, commodity markets, and currency exchanges. These strategies employ long and short positions to profit from the overall market movement caused by significant economic trends and occurrences.

Commodity trading advisers (CTAs) focus on commodity futures based on numerous technical and fundamental strategies. CTAs may include investments in various futures, including commodities, equities, fixed income, and foreign exchange. CTAs employ a variety of models that quantify trends and momentum over different periods. As such, CTAs are suitable for portfolio diversification in both strong trending market periods and severe market stress.

Forms of Hedge Fund Investments

A common characteristic of a hedge fund is that it is set up as a private investment partnership or offshore fund that is most often open to a limited number of investors who can make a substantial initial investment.

An investor can invest in a single hedge fund requiring extensive due diligence and performance monitoring over time. This may involve high minimum investments, lockup periods, and redemption restrictions.

Due to this, investors prefer investing in funds of funds. These are investment funds that hold a portfolio of hedge funds. Funds of funds accommodate investors with smaller amounts and those that lack the requisite expertise for the performance of due diligence and expertise and performance monitoring to invest in hedge funds. Additionally, funds of hedge funds invest in hedge funds across different strategies and management styles, allowing for the diversification of investor funds.

These funds may, however, charge an additional 1% management fee and a 10% incentive fee besides the fees charged by the underlying hedge funds. This substantially increases the fee charges imposed on investors.

Risk and Return Characteristics of Hedge Funds

Hedge fund indices have problems with survivorship bias and self-reporting. However, the HFRI Fund of Funds Composite Index accurately captures the performance of hedge fund portfolios. Due to the additional layer of fees, the measurements presented here may appear to reflect a lower reported return. They, nevertheless, more closely approximate the performance of average hedge funds than HFRI’s composite index of individual funds.

If an analyst uses the Sortino ratio to adjust returns for downside variation, hedge funds do not appear to be as appealing as bonds.

Diversification Benefits of Hedge Funds

The advantages of hedge funds for diversification first gained attention after the dot-com bubble burst in 2000-2002. During this age, they outperformed conventional long-only investment products on a general basis. Consequently, institutional investors increased their exposure to hedge funds.

While the benefits of hedge fund risk diversification may be worth looking at, past experience demonstrates that these benefits may change with time. When choosing a hedge fund manager, investors must perform their due diligence.

Question

Which of the following is most likely a strategy that focuses on the securities of firms that are on the verge of bankruptcy or in actual bankruptcy?

1. Special situations.
2. Fundamental value.
3. Distressed or restructuring.

Solution

The correct answer is C.

Distressed or restructuring is an event-driven strategy that focuses on the securities of firms that are either on the verge of bankruptcy or in actual bankruptcy.

A is incorrect. A special situation is an event-driven strategy. It focuses on opportunities to get involved in the equity of companies engaged in restructuring activities other than acquisitions, mergers, or bankruptcy.

B is incorrect. A fundamental value strategy is a form of equity hedge strategy that uses fundamental analysis to identify companies deemed undervalued and unloved for any number of corporate performance or sector-driven reasons.