In the dynamic world of finance, hedge funds stand out as enigmatic entities that captivate both investors and curious minds alike. These sophisticated investment vehicles have garnered attention for their ability to navigate diverse markets, generate substantial returns, and occasionally even influence market dynamics. However, the workings of hedge funds remain shrouded in complexity, often concealed behind a veil of intricate strategies and distinctive operational mechanisms. This article embarks on a journey to demystify the intricate realm of hedge funds, unraveling the layers that define their operation and exploring the various strategies that drive their pursuit of profitability. From long-short equity plays to intricate quantitative models, and from leveraging to risk management, we delve into the fundamental elements that shape the landscape of hedge fund investing. As we delve deeper into the core mechanics, we aim to equip both novice and seasoned investors with the insights needed to understand the allure, risks, and rewards associated with hedge fund participation.
At their core, hedge funds are specialized investment vehicles that operate with a distinct level of flexibility and complexity. These funds pool capital from accredited investors and institutions, allowing fund managers to execute a diverse array of investment strategies aimed at achieving substantial returns. Unlike traditional investment avenues, hedge funds employ strategies that span from exploiting market inefficiencies and price dislocations to engaging in derivatives trading and leveraging. By actively engaging in both long and short positions across various asset classes, hedge funds seek to capitalize on market opportunities regardless of market direction. Leveraging their expertise, fund managers navigate intricate financial landscapes with the goal of outperforming traditional investment benchmarks, all while striving to manage and mitigate potential risks. The combination of these strategies, coupled with the performance-based fee structure, forms the bedrock of hedge fund dynamics, offering investors a unique chance to tap into the high-risk, high-reward world of sophisticated investing.
Different strategies
Equity hedge (long/short strategy)
The long/short equity strategy consists mainly of combining long and short positions in equity, resulting in portfolios that have a reduced exposure to market risk. Long/short equity funds have existed for decades and represent the largest segment among non-traditional investments. Most long/short stock managers apply the same fundamental analysis as traditional funds, with the difference that they can - at least in theory - generate profits even in phases of market decline. Over the years, the initial strategy has evolved to capture various sources of return and adopt different investment approaches. For example, sector funds have emerged; some managers have evolved towards more quantitative strategies; others have adopted a more active approach, using private equity techniques.
Long/short equity strategies can be assimilated to long only strategies, but unlike the latter, they have four potential sources of return:
- The first source of return is the spread in terms of performance between long and short positions. Ideally, the shares on the long side should rise in value, while those on the short side should decrease in value. This is why long/short investments are often defined as a double alpha strategy, where the term "alpha" refers to the overperformance of an investment. In long/short investments, one alpha can come from the long side (the undervalued securities increase in value) and the other alpha can come from the short side (The overvalued security decreases in value).
- The second source of return is the reimbursement of interest on the proceeds of the uncovered sale that are used as collateral. The share on the loan is deducted from interest on income paid to the fund, but this deduction is usually extremely small for more liquid shares.
- The third source of return is the interest paid on the liquidity that remains as a margin deposit to the broker.
- Finally, the last source of return is the spread in dividends between the long and short position. The contractor must reimburse to the lender the dividends paid on borrowed securities and at the same time receive the dividend on the long position. Although the difference may be small, it should be taken into account when calculating the overall return of a position.
This strategy also has its disadvantages and risks:
- Higher trading costs: the gross exposure of a long/short equity fund is usually higher than its initial capital, which means that the trading costs expressed as a percentage of the initial capital are usually high. Since higher costs are inherent to the strategy, the only way to reduce them is to reduce the fund’s exposure: invest only 50% of the initial capital on both long and short positions and make the transaction costs equal to those of a long-only strategy. - Upper turnover: Long/short equity strategies tend to have a higher turnover than buy and hold strategies. The values of both the long and short portfolios change over time depending on the performance of individual securities and additional trading may be required to rebalance the portfolio. In addition, large market movements could result in further trading in order to avoid margin breaches or liquidity withdrawals.
- Execution delays: a delay in trading short positions could cause the portfolio to have a long bias if in the meantime the long position has already been opened.
- Delays in the bull phases of the markets: Even if they invest in shares, long/short equity funds are unable to capture the share risk premium, during rising markets where their short positions act as a hedge and reduce their market exposure.
- Net long bias: long/short equity funds tend to have a long net bias, i.e. a higher long exposure than a short exposure. This distortion is due to two reasons. First, many newcomers to the universe of long/short equity have a long-only background and consequently their long positions tend to dominate the portfolio. Secondly, once a long/short equity position has been opened, it tends to move towards a long net exposure. In fact, the long title will ideally appreciate in value and increase its weight in the portfolio, while the short one will ideally lose its value and reduce its weight on the wallet. Well balanced long/short equity portfolios then naturally evolve towards a long bias if their trades are successful. To counter this trend, managers need to regularly reduce the size of their long positions
Event driven strategy
An event-driven strategy emerges as a dynamic force within the realm of hedge funds, capitalizing on the ebbs and flows of corporate events that have the potential to reshape financial landscapes. Operating at the intersection of finance and corporate actions, this strategy hinges on identifying and exploiting opportunities arising from mergers, acquisitions, bankruptcies, regulatory shifts, and other significant events. By meticulously analyzing the potential impact of such events on stock prices and market dynamics, hedge funds employing an event-driven approach strategically position themselves to benefit from price dislocations and market inefficiencies. Through well-timed entry and exit points, rigorous due diligence, and the ability to anticipate market reactions, these funds endeavor to navigate the complex terrain of corporate events, aiming to achieve not only financial gains but also a keen understanding of the intricate interplay between corporate decisions and market responses.
Relative value strategy
Within the intricate landscape of hedge fund strategies, the relative value approach stands out as a meticulous and analytical pursuit. This strategy revolves around the art of uncovering mispricings between related financial instruments, driven by factors such as supply and demand dynamics, interest rate differentials, or even perceived market inefficiencies. Hedge funds embracing the relative value strategy meticulously identify assets that are inherently linked, such as options and their underlying stocks, or bonds of similar credit quality but varying yields. Through in-depth quantitative analysis, these funds calculate the fair value of these interconnected instruments and then seek to capitalize on discrepancies between their calculated value and prevailing market prices. The relative value strategy is a testament to the precision with which hedge fund managers navigate complex financial relationships, aiming to derive profit from the convergence of prices that statistical models and meticulous research suggest is inevitable.
Global macro strategy
A global macro strategy operates as a financial compass that navigates the tumultuous waters of the global economy. At its heart, this strategy hinges on the profound impact of macroeconomic forces and geopolitical events on financial markets. Rather than confining itself to the microcosm of individual stocks or sectors, a global macro approach casts a wide net, analyzing worldwide economic indicators, central bank policies, trade dynamics, and political shifts. This strategy empowers astute hedge fund managers to predict and profit from seismic market movements, regardless of their direction. By strategically positioning themselves in currencies, commodities, bonds, and equities, these managers harness the waves of change, leveraging not only their insights but also sophisticated tools like derivatives and leverage. This dynamic and adaptable strategy encapsulates the essence of interconnected global finance, where success is derived from deciphering the intricate dance between economies and markets on a truly global scale.
How can this strategy be applied? For example if the hedge fund discovers geopolitical problems in a key oil-producing region that could cause supply interruptions. In anticipation of a possible drop in oil supplies, the fund purchases oil futures contracts. Furthermore, the fund may take short positions in industries largely reliant on oil, such as airlines and transportation companies, anticipating that their costs will rise as oil prices rise. This strategy tries to capitalize on global commodity interconnection and its impact on numerous sectors. Or if a hedge fund notices that one country's interest rate is much higher than another's. The fund takes a long position in the higher-yielding currency and a short one in the lower-yielding currency, anticipating a probable capital flow towards that currency. The fund seeks to profit from both possible currency appreciation and interest rate income by taking advantage of the interest rate disparity.
Equity market neutral strategy
Most long/short equity fund managers select shares separately for the long and short sides of their portfolio. They pay little attention to the relationship between their long and short positions, or more generally, for the portfolio building process. As a result, their funds often have a long or short net exposure, depending on the set of opportunities available and the manager’s prospects for the short-term direction of the market. In both cases, portfolio performance becomes dependent on market directional movements.
The goal of equity market neutral managers is to avoid any net market exposure in their portfolio. Selling and buying are no longer independent sequential activities; They become correlated and in some cases even simultaneous. Furthermore, long and short positions are regularly balanced to remain neutral to the market at all times, so that the portfolio’s return derives solely from the selection of securities and no longer from market conditions. When properly implemented, this strategy offers the promise of real absolute returns (alpha) without having to endure the sensitivity of the market (beta). The term “Market Neutral” incorporates, however, different investment approaches with varying degrees of risk and neutrality.
Pairs trading is probably the oldest form of equity-market neutral strategy. Its rules are simple: (I) Find shares whose prices should normally move together; (II) take a long/short position when they deviate sufficiently; (III) keep the position open until the prices of the two shares converge or a stop loss level has been reached. The underlying ratio of this strategy is that two shares with similar characteristics that tend to move together and whose respective prices form a balance can only deviate from this balance temporarily.
Whenever, from a historical/statistical perspective, the spread becomes large enough to generate the expectation that it will then return to its long-term average level, you can make a profit by establishing a long/short position. Many models use a kind of distance function to measure co-movements between titles pairs.
The simplest distance between two stocks is the tracking variance, which is calculated as the sum of the square differences between the two standardized price sets. The position is opened when the distance reaches a certain threshold, which could be, for example, two historical standard deviations from its average or a certain percentile of the empirical distribution. The position is closed when the distance reaches another threshold, either with a win (return to average) or with a loss (it reaches a stop loss).
Statistical arbitrage can be seen as an extension of the pairs trading approach in relative pricing. The underlying premise of relative pricing is that groups of shares that have similar characteristics should be priced on average in the same way. However, due to some non-rational, historical or behavioral factors, some temporary discrepancies may be observed. Instead of searching for a few title pairs that deviate from their historical relationship, statistical arbitrators break down and analyze the entire universe of stocks based on different criteria and search for systematic divergences between groups. Their portfolio will typically consist of a large number of long and short positions selected simultaneously: For example, they will buy 20% of the most undervalued shares and sell off 20% of those most overvalued according to some criteria in order to capture the average mispricing between groups.
The criteria selected to break down and analyze the stock universe are the most important elements in the strategy. What arbitrators try to do is use factors that well explain historical stock price movements and that also have some sort of predictability. The challenge is to avoid factors with little explanatory power, or factors that have a temporary impact, and to rely only on intuitive and meaningful ones, whose empirical performance can be easily documented. Examples of such factors are valuation indicators, growth estimates, leverage, dividend rate, revision of profits, momentum, etc. Once the factor is selected, the arbitrator makes a rank of the actions according to it and takes a long position on the best results and short on the worst ones. The resulting portfolio is neutral to that factor and its performance depends on the future ability of the factor to separate the best performers from the worst. Most of the time, this ability is linked to specific market reactions, which can be classified as momentum patterns and reversal patterns in the short, medium and long term. In a momentum pattern, you expect that past winners/losers will be future winners / losers, while in a reversal pattern you expect past losers /losers to be future winners/losers.
With the growing availability of market information and real-time computing power, automatic trading has attracted the interest of an increasing number of hedge equity market neutral funds in recent years. Automatic trading greatly facilitates arbitration on multiple markets and time limits. It can also capture very short-term opportunities, for example a momentum lasting a few minutes or even seconds.
However, to be successful in very high frequency trading, four elements are needed: brainpower (to outline trading rules or learning algorithms), high-frequency historical data (to test trading rules), computational power (to apply selected trading rules in real time) and better execution (to reduce delays and transaction costs).
Arbitrage
Arbitrage strategies form a captivating tapestry within the realm of hedge funds, encompassing a range of tactics that exploit price discrepancies and market inefficiencies. From the intriguing world of merger arbitrage, where funds capitalize on the spread between an acquisition target's current price and the offer price, to statistical arbitrage, where quantitative models identify fleeting misalignments in correlated securities, these strategies share a common thread of swift and precise action. In fixed-income arbitrage, hedge funds seek to profit from yield differentials between bonds with similar risk profiles. Meanwhile, convertible arbitrage focuses on the interplay between convertible bonds and their underlying equities. By adeptly identifying and capitalizing on fleeting windows of opportunity, arbitrage-focused hedge funds orchestrate intricate maneuvers, aiming to create value by restoring equilibrium within financial markets. The appeal of arbitrage strategies lies not only in their potential for consistent returns but also in their embodiment of the financial world's perpetual quest for balance amidst ever-shifting market forces.
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