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Three classic strategies demystified

Will Hodges unravels the three classic hedge fund strategies: relative value, event-driven and directional
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*Hedge fund strategies - or how hedge funds make their investment decisions - are numerous. There is no standard strategy. *

*Some hedge funds only ever follow one strategy. Some will follow a few strategies at any one time, and change them according to market conditions. Other hedge funds have no set strategy and invest opportunistically in any situation on its merits as it arises. *

In general, all hedge funds' investment strategies can be grouped in to three main categories...

1. Relative Value (or Arbitrage) Strategies

Pure Arbitrage

Pure arbitrage is the exploitation of an actual price inefficiency, where the inefficiency is a discrepancy between the prices of two related securities.

A classic arbitrage is finding the same security or asset quoted in two different markets at different prices. The hedge fund seeks to buy the asset at the lower price in one market, and sell it at the higher price in the other. Given the asset is the same, this is almost a riskless trade.

Another opportunity for arbitrage occurs if a fund manager observes a discrepancy in price between, for example, the current trading price of a stock and the price of a derivative instrument of that stock, then arbitrage can occur.

Because pure arbitrage is virtually risk free returns are fairly modest. For this reason, only a few hedge funds follow a pure arbitrage strategy.

A fund manager who adopts a pure arbitrage strategy may well choose to maximise returns by leveraging the investment highly.

Leveraging the investment means borrowing money from lenders (because it is cheaper to spend borrowed money than it is to use invested funds) and making the same bet, or investment, several times over.

Once the 'reward' comes in, the manager can pay back the lenders their initial loan with a relatively small level of interest, and keep the difference between the interest on the loan repaid and the gain locked in from the arbitrage.

Example of Pure Arbitrage

To use a simple example, let us assume that shares in Newcastle United are currently trading on the equities market at £10, and a Newcastle United futures contract due in three months is priced at £15. The futures contract is the promise to buy the Newcastle United stock at a predetermined price.

A fund manager can simultaneously buy the stock (£10 a share) and sell the contract (at £15). This locks in a £5, or 50% gain, before transaction and management costs are taken into consideration.

Relative Value / Long - Short

More hedge funds will adopt an arbitrage strategy better known as 'relative value'.

These strategies will aim to make investments that exploit price differences, but carry more risk than arbitrage in its pure form.

Such strategies may use the technique of short selling, a typical example of the aggressive tactics employed by hedge funds.

To 'go short' is to borrow a security that you believe is going to drop in price, to sell it on the market at its current price and then to buy it back after a certain period of the time when the price has dropped. Once you have bought the security back at a reduced price (and thereby made a profit), you give it back to the lender, pay a small transaction charge and count your winnings.

In relative value strategies, arbitrageurs will take a view on how the values of two securities will move with respect to one another, as opposed to the market as a whole (hence the term 'relative value'), and try to exploit the relative prices of the two securities. They are not bothered how the whole market will move, just the two securities, relative to each other.

Example of Equity Long / Short

You take the view that Microsoft's attempts to buy Facebook will fail, causing its share price, currently £20, to drop.

You go to a stock lender and borrow 10 shares at £20 each. You then sell these shares on the market, making £200 in the process.

You have agreed with the stock lender that you will pay him back his shares within one month, and you pay him an administration fee of 5% (£1 per share, £10 in total).

Two days later, Microsoft announces it has failed in its bid to buy out Facebook, causing its share price to fall to £8.

You go out and buy 10 shares at £8 each, costing you £80. You gives the shares, and the interest of £10, back to the stock lender, leaving you with £110 of the £200 you made when you sold the borrowed shares.

2. Event-Driven Strategies

Event-driven strategies do exactly what it says on the tin - they take advantage of out-of-the ordinary events in a company's life cycle and the effects such events will likely have on the prices of the stocks of those corporates.

Much like the tumultuous changes over the course of our own lives, there are a number of events that might take place from the birth of a company.

At any stage during its life, a company may find itself embarking on a tentative love affair (joint ventures), getting married (mergers or acquisitions), have a child (spin offs), getting divorced (de-conglomeratization), having a mid-life crisis (restructurings) or dying (liquidation).

Clever market experts, who follow the trials and tribulations of companies and sectors day-in, day-out, and as such are in a good position to predict what will happen in the next chapter of a company's story, will try to make money out of these events by trading the stocks of the companies involved in the deal.

Merger Arbitrage

A common example of event-driven strategies is merger arbitrage.

In the case of a proposed acquisition, the hedge fund manager will take a view on the difference in price of the value offered for a target company and the current market value of that target company.

The risk inherent in such an investment strategy is apparent - it is by no means certain that the deal will go ahead, or that the stock prices will behave as expected.

If the deal unravels (for example if Facebook shareholders reject the offer, or antitrust laws prevent the deal from going ahead), the stock of the acquirer, in this case Microsoft, may go up (this is known as 'relief') whilst the price of Facebook shares may fall. in this case, the hedge fund will have made a loss.

The hedge fund may take a position after an acquisition attempt has been announced or alternatively may try and anticipate the deal before it is announced. There is likely to be the chance for greater profit in the latter sceanrio.

This is akin to buying property in Stratford after the decision to hold the Olympics there was announced. Investors immediately piled in to take advantage of anticipated price rises. But a smarter strategy still would have been to buy property there before the annoucement was made. After all, there was already a 50% chance that it would win.

In the second approach, investment decisions will be based either on rumours and speculation, and therefore carry increased risk, or on confidential information. If the information should have been known only to insiders, it is an illegal practice known as insider trading.

There are several other types of event-driven hedge funds, including Special Situations, Distressed Securities and Activist Funds.

Example of Merger Arbitrage

To return to the Microsoft example, say Microsoft puts in a cash bid for Facebook of £10 per share, and that Facebook is currently trading at £8 per share. The merger arbitrageur will assume two things: 1) the acquisition will go ahead, and 2) the price of shares in Facebook, the target company, will converge with (rise to meet) the price per share detailed in the offer from Microsoft (£10 per share). The clever hedge fund manager will buy shares in, or 'go long' on, Facebook, assuming that the value of these will rise, but hedges against the risk of the deal not going ahead and the price of Facebook shares not rising by selling short Microsoft stock.

Activism

Activism, which is predatory in nature, is another good example of the aggressive tactics employed by hedge funds to ensure positive returns. It involves funds taking sizeable positions, by investing equity, in small and troubled companies and then using its control position to encourage, or force, changes in the company, thereby driving up its share price.

Whatever event-driven strategy a hedge fund manager chooses to use, they have to take a view on a rumoured or actual change in the fundamental structure of a company, bet on it, and hope that it is on the nose. The risk is that the market will react unpredictably and skewer the expected outcome of the event.

3. Directional Strategies

Directional strategies seek to take advantage of major market trends rather than focusing on the prices of single stocks or securities.

They are called directional because they are essentially bets on the direction of the price of a certain economy, currency, commodity or interest rate.

They are either less hedged or not hedged at all.

Global Macro

The best-known directional strategy is the global macro approach.

Global macro funds take a top-down approach to investing, meaning the hedge fund research analysts will start off looking at a very broad range of indicators before narrowing down to a certain investment area.

As such, global macro fund managers have the broadest mandate of any hedge fund, with the option of investing in almost any market and using almost any financial instrument.

To make such directional (unhedged) investments, global macro fund managers will try to anticipate events that will produce price changes in capital markets by analysing how political events, global macro-economic factors and other external factors might influence the value of certain financial instruments.

If this top-down approach allows a fund manager to identify a market trend, he or she will use a specific financial market analysis to decide when and how (using what financial instruments) the investment should be made.

Such an opportunistic investment strategy requires an astute and intuitive fund manager, who can use experience, skill and insight to seek out subtle and lucrative investment opportunities.

Example of Global Macro

A global macro fund may start by looking at global economies, and after research might decide that emerging markets are good economies to invest in.

Further research might suggest that of all emerging markets, most money can be made by investing in one of the BRIC economies, and that of these it is really India that is likely to see the most growth over the next 12 months.

The hedge fund may then decide to invest a certain amount of its assets in Indian equities, for example, assuming that Indian equities are currently underpriced and that increased financial nouse and experience will mean that the market will recognise this underpricing over the next 12 months and correct the equity market accordingly, sending the price of Indian equities sky-high and ensuring that Mr Hedge Fund Manager can get a new Aston Martin by the end of the year.

Summary

The three categories of hedge fund investment strategy introduced her are merely the most common and traditionally used practices.

Hedge fund strategies, like the cut of jeans of the bands headlining at Glastonbury each year, are anything but static, changing with markets and constantly being pushed to new boundaries.

What seems unthinkable and eccentric one day could quite feasibly be the gig we are all queuing up at the Box Office to get tickets for at 5am the next day.

It is this constant reinvention and metamorphosis, this realigning of parameters and creative inspiration that makes the hedge fund world the exciting, coveted and yet consistently misunderstood area that it is. And, like our favourite bands, it is this air of mystique and lack of fully-fledged social ability that makes them so mouth-wateringly cool.


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