|
The term 'hedge' in hedge funds stems from the fact that such managers look to eliminate (hedge) traditional risk exposures (such as equity risk and interest rate risk) whilst still trying to earn a return from mispricings in the market place. Many hedge funds do this via the use of derivatives, whereby they look to remove broad market risks from portfolios. Relative value hedge funds, however, look to do this by taking opposite positions in market securities; buying undervalued securities (longs) and selling similar, but overvalued, securities (shorts).
Many relative value strategies might be referred to as arbitrage plays. This means that the positions taken are meant to provide 'risk-free' returns. Pure arbitrage, however, is only really available where there has been a major market breakdown, with buyers and sellers not being able to adequately communicate or discover fair prices. This might occur in markets that are not open at the same time, but which trade similar securities, or where derivative contracts are complex enough to 'hide' relevant factors for determining fair price. For most liquid, efficient and modern markets, such occasions have become a rarity. This means that hedge fund managers have had to look for more extensive avenues to find low risk, quasi-arbitrage opportunities.
In the relative value space, there are a number of key strategies that look to take advantage of consistent mispricings. These include:
- Market neutral - These are generally equity managers that look to buy and short-sell shares. This is often done with 'pairs trading', whereby managers will look to find very similar stocks (e.g. same industry and characteristics) but where one is expected to outperform (long) and the other is expected to underperform (short). Thus, the position is likely to have very little net exposure to the industry, but will eke out a return based on the relative performance
- Merger arbitrage - This strategy is sometime lumped in the 'event-driven' hedge fund strategy basket as it relates to a distinct corporate event (i.e. when a company looks to acquire a target company). However, this is similar to other market neutral strategies whereby the acquiring company's shares usually underperform and the target company's shares often outperform
- Convertible arbitrage - This strategy involves the trading of equity, convertible shares (hybrids) and derivatives over the same company. Such a manager will generally look for mispricings of the convertible share, which contains an embedded option by comparing its price with that of the ordinary share and separate option (again, buying the position which is undervalued and selling the position that is overvalued). This strategy might be reasonably 'risk-free', but can come with liquidity risk; generally in the convertible share
- Credit arbitrage - Hedge funds might also look to take advantage of mispricings further up the capital structure by looking for mispricings in a company's debt issues. This may be between debt of different quality issued by the same company (e.g. secured vs unsecured) or may be between debt issues of very similar companies. This can also be mispricings that can occur between different levels of asset-backed securities (e.g. senior tranche vs mezzanine tranche)
- Fixed income arbitrage - Hedge funds can also look for arbitrage opportunities across government bond securities. This is generally based on yield curve shape changes, but is also driven by differences in tradeability of different maturities (i.e. popular vs unpopular securities). Whilst such mispricings naturally exist, this type of mispricing is likely to be very small and also come with some liquidity risk.
Much of the 'low-risk' profit earned through these strategies is in itself very low. This means that most hedge funds need to take on substantial levels of leverage in order to earn returns that cover their fees and provide adequate returns to fund investors. This is generally accomplished through the extent of the level of short sales that is taken on (e.g. A fund with $100 worth of capital might be able to sell $1000 worth of securities and buy $1000 worth of securities, effectively leveraging their net assets 10-fold). This, however, can add different risks to hedge funds, especially if positions do not move as expected or markets breakdown in unexpected ways.
|
