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Innovative Hedge Fund Strategies for Well Informed Investors

The bulk of hedge fund assets are invested in funds that employ "long / short" equity strategies. Other hedge funds use alternative strategies such as selling short, arbitrage, trading options or derivatives, using leverage, investing in seemingly undervalued securities, trading commodity and FX contracts, and attempting to take advantage of the spread between current market price and the ultimate purchase price in situations such as mergers. When strategies become extremely complex they may acquire potential and unanticipated risk of catastrophic losses as in the case of Long-Term Capital Management.

Equity Long Short

Equity long short is (3Q 2006) the most ubiquitous hedge fund strategy globally representing some 27% of North American hedge fund assets, 38% in Europe and 69% in Asia. Equity long short investing involves buying long equities that are expected to increase in value and selling short equities that are expected to decrease in value either in absolute terms or in relative terms.

Typically equity long short investing is based on what is termed 'bottom up' fundamental analysis of companies driving the decisions whether to hold a stock long or sell it short. There is usually also a 'top down' basis for risk managing the equity portfolio to diversify risk by geography, industry, sector and macroeconomic factors. With time various evolutions of this strategy have emerged.

The equity long short space is rich with variety. Within equity long short managers there are those who specialize in a value approach or a growth approach. Similarly there are a variety of trading styles where a manager may be a more frequent or dynamic trader or a more long term investor. There are managers who focus on certain industries and sectors or certain regions.

A special subset of equity long short manager is the so-called Market Neutral equity manager. Here, the long and short portfolios of the fund are balanced so that some form of market neutrality is achieved. This neutrality can be characterised with respect to the dollar exposure, which is the simplest metric, or it can be characterised with respect to beta-adjusted dollar exposure which balances the equity positions based on their sensitivity to the market as a whole. Depending on the managers' choice of benchmark(s), market neutrality can be imposed at the global portfolio level or it can more rigorously be imposed at the regional, industry or sector or market capitalization level resulting in a more tightly hedged portfolio.

Typical risk metrics for equity long short funds are gross and net exposures. Gross exposure equals long exposure plus the absolute value of short exposure. For example, for 100 USD of capital, if a fund is 150 USD long and 50 USD short, it means that gross exposure is 150 + 50 = 200 USD or 200%. Net exposure is long exposure less short exposure and in our example above would be 100 - 50 = 50 USD or 50%.

The market neutral definition typically admits a variation of plus to minus 10% in net exposure.

Equity Long/Short funds and-- to a lesser extent-- Equity Market Neutral funds can manage exposure through the use of derivatives such as options or futures on market indexes. Some managers refer to this technique as the provision of Portable Alpha.


Risk arbitrage

One very common hedge strategy is to buy shares of a company that is in the process of a merger or acquisition. The company's stock has an announced price that it will be worth on the date of the merger, so if the stock is under that value prior to the merger, it is a safe investment to purchase the stock and wait. This strategy can be risky, as there is no assurance the merger will be finalized and the stock may be left at its current value or drop in value. Frequently, the trader will also short sell the stock of the acquiring company in addition to buying the stock of the target.

Most of the early hedge funds employed this strategy. They became very popular as a way of seeing gains better than the investment grade bond market, while still having low risk.

However the side effect of this popularity was to dramatically increase the interest in all of the non-standard investment strategies, and soon other funds were being set up with new strategies aimed primarily at high growth. Although there is no hedging in these cases, the term is still used for these funds as well.

Some people break the hedge fund universe into seven broad classifications: (1) event driven, (2) fixed-income arbitrage, (3) global convertible bond arbitrage, (4) equity market-neutral, (5) long/short equity, (6) global macros, and (7) commodity trading.

Risk arbitrage, is a trading strategy often associated with hedge funds.

Two principal types of arbitrage are possible:

In a cash merger, an acquirer proposes to purchase the shares of the target for a certain price in cash. Before the acquisition is completed, the stock of the target trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.

In a stock for stock merger, the acquirer proposes to buy the target by exchanging its own stock for the stock of the target. An arbitrageur will then short sell the acquirer and buy the stock of the target. After the merger is completed, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. The arbitrageur delivers the converted stock into her short position to complete the arbitrage.

If that were all there was to it, then everyone would do it immediately, and any possible gain would disappear very quickly. But there is more to it, the risk that the deal won't go through or the closing will be materially delayed, because of either party's inability to satisfy certain closing conditions such as failure to obtain the requisite shareholder approval, failure to receive antitrust and other regulatory clearances, or occurrence of a "material adverse effect" (which may change the target's or the acquirer's willingness to consummate the transaction). Such possibilities put the risk in the term risk arbitrage.

Additional complications can arise in stock for stock mergers when the exchange ratio is not constant but changes with the price of the acquirer. These are called "collars" and arbitrageurs use options-based models to value deals with collars. In addition, the exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.

When hedge fund strategies are sorted into categories, risk arbitrage is sometimes included with other forms of arbitrage such as relative value, volatility arb, convertible arb, and stat arb. But it can also be included as one among the event driven strategies.

Event driven strategies

Event driven strategies are unaffected by the general direction of markets or national policies. The events that drive event-driven funds are specific to enterprises -- chiefly mergers, takeovers, bankruptcies, and the issuance of securities.

Because of its concern with micro triggering events, this family of strategies is also sometimes called bottom up as opposed to top down.

Sometimes an event-driven hedge fund will focus upon one of those bottom-up strategies in particular, in which case it may be referred to as a risk arbitrage, a distressed securities, or a Regulation D fund, whichever name then applies.

But event-driven multi-strategy funds, as the term implies, can keep a finger in each of those pies. This provides diversification and evens out results over the business cycle, because while merger-oriented funds (i.e. risk arbitrageurs) and Regulation D funds (concerns with small-cap securities issuance) are busiest during times of boom, the distressed-securities strategy finds amplest opportunities during times of bust

Some Funds of Funds Examples

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