Mutual Funds, ETFs, and Hedge Funds
4.6 Hedge Fund Strategies
In this section we will discuss the strategies followed by hedge funds. Our classification is similar to the one used by the Barclay Hedge Fund Indices, which provides indices tracking hedge fund performance. Not all hedge funds can be classified in the way indicated. Some follow more than one of the strategies mentioned and some follow strategies that are not listed. (For example, there are funds specializing in weather derivatives.)
4.6.1 Long/Short Equity
As described earlier, long/short equity strategies were used by hedge fund pioneer Alfred Winslow Jones. They continue to be among the most
popular of hedge fund strategies. The hedge fund manager identifies a set of stocks that are considered to be undervalued by the market and a set that are considered to be overvalued. The manager takes a long position in the first set and a short position in the second set. Typically, the hedge fund has to pay the prime broker a fee (perhaps 1% per year) to rent the shares that are borrowed for the short position. (See Chapter 5 for a discussion of short selling.)
Long/short equity strategies are all about stock picking. If the overvalued and undervalued stocks have been picked well, the strategies should give good returns in both bull and bear markets. Hedge fund managers often concentrate on smaller stocks that are not well covered by analysts and research the stocks extensively using fundamental analysis, as pioneered by Benjamin Graham. The hedge fund manager may choose to maintain a net long bias where the shorts are of smaller magnitude than the longs or a net short bias where the reverse is true. Alfred Winslow Jones maintained a net long bias in his successful use of long/short equity strategies.
An equity‐market‐neutral fund is one where longs and shorts are matched in some way. A dollar‐neutral fund is an equity‐market‐neutral fund where the dollar amount of the long position equals the dollar amount of the short position. A beta‐neutral fund is a more sophisticated equity‐market‐neutral fund where the weighted average beta of the shares in the long portfolio equals the weighted average beta of the shares in the short portfolio so that the overall beta of the portfolio is zero. If the capital asset pricing model is true, the beta‐neutral fund should be totally insensitive to market
movements. Long and short positions in index futures are sometimes used to maintain a beta‐neutral position.
Sometimes equity‐market‐neutral funds go one step further. They maintain sector neutrality where long and short positions are balanced by industry sectors or factor neutrality where the exposure to factors such as the price of oil, the level of interest rates, or the rate of inflation is neutralized.
4.6.2 Dedicated Short
Managers of dedicated short funds look exclusively for overvalued
companies and sell them short. They are attempting to take advantage of the fact that brokers and analysts are reluctant to issue sell recommendations—
even though one might reasonably expect the number of companies
overvalued by the stock market to be approximately the same as the number of companies undervalued at any given time. Typically, the companies
chosen are those with weak financials, those that change their auditors regularly, those that delay filing reports with the SEC, companies in
industries with overcapacity, companies suing or attempting to silence their short sellers, and so on.
4.6.3 Distressed Securities
Bonds with credit ratings of BB or lower are known as “non‐investment‐
grade” or “junk” bonds. Those with a credit rating of CCC are referred to as
“distressed” and those with a credit rating of D are in default. Typically, distressed bonds sell at a big discount to their par value and provide a yield that is over 1,000 basis points (10%) more than the yield on Treasury
bonds. Of course, an investor only earns this yield if the required interest and principal payments are actually made.
The managers of funds specializing in distressed securities carefully
calculate a fair value for distressed securities by considering possible future scenarios and their probabilities. Distressed debt cannot usually be shorted and so they search for debt that is undervalued by the market. Bankruptcy proceedings usually lead to a reorganization or liquidation of a company.
The fund managers understand the legal system, know priorities in the event of liquidation, estimate recovery rates, consider actions likely to be taken by management, and so on.
Some funds are passive investors. They buy distressed debt when the price is below its fair value and wait. Other hedge funds adopt an active
approach. They might purchase a sufficiently large position in outstanding debt claims so that they have the right to influence a reorganization
proposal. In Chapter 11 reorganizations in the United States, each class of claims must approve a reorganization proposal with a two‐thirds majority.
This means that one‐third of an outstanding issue can be sufficient to stop a reorganization proposed by management or other stakeholders. In a
reorganization of a company, the equity is often worthless and the
outstanding debt is converted into new equity. Sometimes, the goal of an active manager is to buy more than one‐third of the debt, obtain control of a target company, and then find a way to extract wealth from it.
4.6.4 Merger Arbitrage
Merger arbitrage involves trading after a merger or acquisition is announced in the hope that the announced deal will take place. There are two main types of deals: cash deals and share‐for‐share exchanges.
Consider first cash deals. Suppose that Company A announces that it is prepared to acquire all the shares of Company B for $30 per share. Suppose the shares of Company B were trading at $20 prior to the announcement.
Immediately after the announcement its share price might jump to $28. It does not jump immediately to $30 because (a) there is some chance that the deal will not go through and (b) it may take some time for the full impact of the deal to be reflected in market prices. Merger‐arbitrage hedge funds buy the shares in company B for $28 and wait. If the acquisition goes through at
$30, the fund makes a profit of $2 per share. If it goes through at a higher price, the profit is higher. However, if for any reason the deal does not go through, the hedge fund will take a loss.
Consider next a share‐for‐share exchange. Suppose that Company A announces that it is willing to exchange one of its shares for four of
Company B's shares. Assume that Company B's shares were trading at 15%
of the price of Company A's shares prior to the announcement. After the announcement, Company B's share price might rise to 22% of Company A's share price. A merger‐arbitrage hedge fund would buy a certain amount of Company B's stock and at the same time short a quarter as much of
Company A's stock. This strategy generates a profit if the deal goes ahead
at the announced share‐for‐share exchange ratio or one that is more favorable to Company B.
Merger‐arbitrage hedge funds can generate steady, but not stellar, returns. It is important to distinguish merger arbitrage from the activities of Ivan
Boesky and others who used inside information to trade before mergers became public knowledge.8 Trading on inside information is illegal. Ivan Boesky was sentenced to three years in prison and fined $100 million.
4.6.5 Convertible Arbitrage
Convertible bonds are bonds that can be converted into the equity of the bond issuer at certain specified future times with the number of shares received in exchange for a bond possibly depending on the time of the conversion. The issuer usually has the right to call the bond (i.e., buy it back for a prespecified price) in certain circumstances. Usually, the issuer announces its intention to call the bond as a way of forcing the holder to convert the bond into equity immediately. (If the bond is not called, the holder is likely to postpone the decision to convert it into equity for as long as possible.)
A convertible arbitrage hedge fund has typically developed a sophisticated model for valuing convertible bonds. The convertible bond price depends in a complex way on the price of the underlying equity, its volatility, the level of interest rates, and the chance of the issuer defaulting. Many convertible bonds trade at prices below their fair value. Hedge fund managers buy the bond and then hedge their risks by shorting the stock. (This is an
application of delta hedging, which will be discussed in Chapter 8.) Interest rate risk and credit risk can be hedged by shorting nonconvertible bonds that are issued by the company that issued the convertible bond.
Alternatively, the managers can take positions in interest rate futures
contracts, asset swaps, and credit default swaps to accomplish this hedging.
4.6.6 Fixed Income Arbitrage
The basic tool of fixed income trading is the zero‐coupon yield curve, the construction of which is discussed in Appendix B. One strategy followed by hedge fund managers that engage in fixed‐income arbitrage is a relative value strategy, where they buy bonds that the zero‐coupon yield curve
indicates are undervalued by the market and sell bonds that it indicates are overvalued. Market‐neutral strategies are similar to relative value strategies except that the hedge fund manager tries to ensure that the fund has no exposure to interest rate movements.
Some fixed‐income hedge fund managers follow directional strategies where they take a position based on a belief that a certain spread between interest rates, or interest rates themselves, will move in a certain direction.
Usually they have a lot of leverage and have to post collateral. They are therefore taking the risk that they are right in the long term, but that the market moves against them in the short term so that they cannot post collateral and are forced to close out their positions at a loss. This is what happened to Long‐Term Capital Management (see Business Snapshot 22.1).
4.6.7 Emerging Markets
Emerging market hedge funds specialize in investments associated with developing countries. Some of these funds focus on equity investments.
They screen emerging market companies looking for shares that are
overvalued or undervalued. They gather information by traveling, attending conferences, meeting with analysts, talking to management, and employing consultants. Usually they invest in securities trading on the local exchange, but sometimes they use American Depository Receipts (ADRs). ADRs are certificates issued in the United States and traded on a U.S. exchange. They are backed by shares of a foreign company. ADRs may have better liquidity and lower transaction costs than the underlying foreign shares. Sometimes there are price discrepancies between ADRs and the underlying shares giving rise to arbitrage opportunities.
Another type of investment is debt issued by an emerging market country.
Eurobonds are bonds issued by the country and denominated in a hard currency such as the U.S. dollar or the euro. Local currency bonds are bonds denominated in the local currency. Hedge funds invest in both types of bonds. They can be risky: countries such as Russia, Argentina, Brazil, and Venezuela have defaulted several times on their debt.
4.6.8 Global Macro
Global macro is the hedge fund strategy used by star managers such as George Soros and Julian Robertson. Global macro hedge fund managers carry out trades that reflect global macroeconomic trends. They look for situations where markets have, for whatever reason, moved away from equilibrium and place large bets that they will move back into equilibrium.
Often the bets are on exchange rates and interest rates. A global macro strategy was used in 1992 when George Soros's Quantum Fund gained $1 billion by betting that the British pound would decrease in value. More recently, hedge funds have (with mixed results) placed bets that the huge U.S. balance of payments deficit would cause the value of the U.S. dollar to decline. The main problem for global macro funds is that they do not know when equilibrium will be restored. World markets can for various reasons be in disequilibrium for long periods of time.
4.6.9 Managed Futures
Hedge fund managers that use managed futures strategies attempt to predict future movements in commodity prices. Some rely on the manager's
judgment; others use computer programs to generate trades. Some
managers base their trading on technical analysis, which analyzes past price patterns to predict the future. Others use fundamental analysis, which
involves calculating a fair value for the commodity from economic, political, and other relevant factors.
When technical analysis is used, trading rules are usually first tested on historical data. This is known as back‐testing. If (as is often the case) a trading rule has come from an analysis of past data, trading rules should be tested out of sample (that is, on data that are different from the data used to generate the rules). Analysts should be aware of the perils of data mining.
Suppose thousands of different trading rules are generated and then tested on historical data. Just by chance a few of the trading rules will perform very well—but this does not mean that they will perform well in the future.