Ch8 Individual Hedge Fund Strategies

1. Equity Hedge Strategies
1-1. Long/Short Equity
- Long a core set of stocks
- Short sales of other borrowed stocks (partially or fully hedging): generating returns when price declines, hedging brad market risk, and earning interest on proceeds
- leverage
- exposure to broad equity risk premium, small firm & value stock risk premia
- significant alpha -> experience- & skill-driven
- dead weight in traditional index-benchmark equity investment

- most managers have a long bias
- the focus of strategy: stock selection with regional, sector-specific or particular style emphasis
- NOT market timing, prediction of the broad stock market direction

e.g.) long undervalued and short overvalued, core long positions with a partial hedge overlay with short index futures, long OTM puts and short covered call

Bottom-Up Approach
- fundamental analysis -> determination of undervalued or overvalued
- analysis of industry sector
- qualitative analysis: a detailed due diligence process & analysis of maangement

Top-Down Approach
- economic trends & upcoming investment themes in certain industry sectors: vlaue vs. growth
- inefficiencies on micro & small capitalization stocks

Index
- HFR Long/Short Equity Hedge Index
- CSFB Tremont Long/Short Equity Index


1-2. Equity Market Neutral
- simultaneously long & short matched stock positions -> taking advantage of a relative outperormance of the long positions vs. the short positions
- generating returns that are completely uncorrelated to the overall equity market
- insulating portfolios from broad market rist factors = total portfolio net exposure = zero; dollar neutral, country neutal, currency neutral, sector neutral, size neutral, style neutral (value vs. growth)

Statistical Arbitrage
- model-based short-term trading
- quantitative & technical analysis
- profit opportunity in undervalued & overvalued; mean-reversion
- pair trading: long & short position in two stocks that are closely related
- black box investing; characteristics of the model are usually not disclosed to investors

three Steps
- screening & ranking: rule-based decision
- stock selection: value factors (rule-based decition; selection criteria: price-to-book, price-to-earning, price-to-sales, discounted CF, ROE, operating margins, earnings growth) or momentum factors (price or earnings momentum, moving average, relative strength & trading volumes)
- portfolio construction

e.g.) long outperformed (winner stocks) & short underperformed (loser stocks),
Fama-French HML (high minus low; long high book-to-market stock & short low book-to-market), SMB (small minus big; long small firms & sell large cap), and UMD (up minus down; long recent winner & short recent loser)

Market Neutral Long/Short Equity


1-3. Equity Market Timing
- mutual fund timing
- using a variety of technical trading models to screen the global equity markets for short-term opportunities in particular industry or geographic sectors
- switch between long equity exposure (taken at favorable moment) and risk-free
- inefficiencies of equity markets
- technical trend-following models based on short & medium-term momentum -> buy and sell signals

two strategies:
- sector timing: micro upward trends in single industry sectors **stale prices
- time zone arbitrage

studies:
- small cap lag the price action of large cap by 1~2 days


1-4. Short Selling
- selling of stocks not currently owned by the seller in order to take a directional bet on their anticipated price decline
- short rebate interest: interest earnings on proceeds
- substantial collateral: 30~50% of the market value
- short with derivatives or short with long/OTM call options (= long/short equty strategy with a short bias)
- key driver = security selection

payoff:
- profit from buying back stock at a lower price
- short debate interest

approaches:
- bottom-up approach: aggressive accounting techniques

consideration:
- share availability
- stability of the borrowing (call back)
- level of short rebate interest
- short squeezes
- invers relationship between performance and exposure


2. Relative Value Strategies
2-1. Convertible arbitrage
- long convertible security and short underlying stock
- equivalent to holding a bond position plus an option on some underlying stock
- arbitrage opportunities by identifying pricing disparities between the equity and the convertible bond
- buying volatility (cheap convertible securities) & hedging
- leverage: 1:1 to 5:1
- credit risk & interest risk

e.g.) long convertible bonds & short underlying stock/option or index futures/options,
low credit quality or distressed convertibles & stock

income sources:
- static returns: coupon & short stock rebates
- gamma trading on stock volatility
- price inefficiencies

Static Returns
- coupon/dividend plus short rebate (minus dividends)
- consideration: credit risk, omicron (dependency between bond price and credit spread)
- related to systematic risk factor; not related to pricing inefficiency

Gamma Trading
- long valatility; achieved from long gamma & long vega
- Long Gamma: delta neutral = when a stock price increases, delta increases, and sells more stock
- being long gamma: changing delta always works out in favor of the overall position of long convertible bond with a hedged short position in the underlying stock
- being long vega: as the stock price volatility changes, the convertible's value will change due to the commensurated change in the inherent option value (conversion premium)
- long gamma & vega has little to do with exploiting pricing inefficiencies -> driver of convertible arbitrage strategy
- short theta

2-2. Fixed Income Arbitrage
- profits by trading the spread relationship (spread position) between related fixed income securities and their derivatives to profit from relative movements or to accrue positive carry retusns over time
- neutralizing exposure to most systematic risk factors (e.g. yiedl curve changes, interest rate, credit, FX, etc)
- short volatility strategies
- flight to quality: when interest rates move rapidly, creadit spreads widen & liquidity dries up
- complexity premium

e.g.) spread trades
- yield curve trades (bonds with different maturities), corporate vs. Treasury yield spreads, municipal vs. Treasury yield spreads, cash vs. future, on-the-run vs. Treasury bonds
- arbitrage between similar bonds: different duration
- Butterflies (yield curve arbitrage): e.g. long cheap 5-year, 7-year & short expensive 6-year
- Basis trades: spread between physical securities and their futures
- Asset swap: long fixed-rate bonds vs. pay fixed positions in interest swaps or vice versa (reverse asset swaps)
- TED spread: spread between T-bill futures and Eurodallar futures
- yield spread between on-the-run & off-the-run bonds

other strateges (non-market neutral)
- yield curve spread trading based on a forecast of the directional changes of the yield curve
- credit spread trading
- cross-currency government vs. government spread trades
- ABS
- MBS against CMO

pricing inefficiencies:
- agency biases
- structural reasons: tax, accounting or regulatory issues
- market segmentation

2-3. Volatility Arbitrage
- benefit from the level and change of volatilities in particular instruments
- long position in cheap volitalities and short position in expensive volatilities

2-4. Capital Structure Arbitrage
- long and short positions in difference financial instruments within the capital structure of an idividual company.
- discrepancies movements of the equity & bond prices

e.g.) buying bond & selling stock vice versa, short CDS & long a stock put vice versa, long one bond issue & short another bond tranche

3. Event-Driven Strategis
- event: firm-specific (idosyncratic nature)

strategies:
- cash takeovers & stock-for-stock mergers (merger arbitrage)
- divestments, spin-offs, special dividends and refinancings
- ligigation plays: legal case such as bankruptcy
- post-bankruptcy: companies emerging out of Chapter 11 proceedings
- index events: changes in index composition
- holding company and share calss arbitrage: buying shares of holding company & selling shares of its assets or vice versa

3-1. Merger Arbitrage
Before the effective date of a merger, the stock of the acquired company will typically sell at a discount to its acquisition value as officially announced.
- buying stock in a company being acquired and selling stock in its acuqirers.

3-2. Distressd Securities
- investing in the debt and/or equity of companies having financial difficulty
- deeply discounted prices
- successful reorganization and profitable returns

3-3. Regulation D
- investing in publicly listed companies, mostly of micro and small cap, that are in need of capital through privately negotiated structure.
- private equity placements pursuant to Regulation D
- the investment is structured in the form of privately placed, unregistered, high coupon, convertible securities or debentures with maturities ranging anywhere from 18 to 60 months.
- invetment are made pursuant to an exemption from registration as provided by Regulation D of the U.S. Securities Act of 1933
- selling the fully tradable and registered shares in the public markets & realizing the spread between the market price and the discounted price of the stock (15 ~ 40%)
- bottom-up analysis

4. Opportunistic/Global Macro Strategies
- bets on the direction of a market, a currency, an interest rate, a commodity, or any macroeconomic variable
- high leverage & extensive use of derivatives

4-1. Futures Funds (Managed Future Funds)
- commodity pools that include commodity trading advisor funds
- bets on directional moves in the positions they hold in a single asset class, such as currency, fixed income, or commodities and tend to use may actively traded futures contracts

Systematic Strategies
- generating buy & sell decisions from computer models combining various technical factors and indictors
- executed in highly liquid markets with low transaction costs
- trend-following: dominant trading style
- long straddle
- short-term models using counter-trend signals
- trading based on technical pattern recognitions (Elliot waves)
- Taking positions according to the degree to which a commodity is trading in contango or backwardation
- overfitting (curve fitting)

Discretionary Strategies
- proprietary approaches based on fundamentals
- directional long-term positions based on fundamentals & short-term bets based on information flow

4-2. Emerging-Market Funds
best on all types of securities in emerging markets


5. Funds of Funds
- created to allow easier acces to small investors as well as instituional investors

benefits:
- retailing
- access
- diversification
- expertise
- due diligence process

drawbacks:
- fee
- performance
- diversification is a two-edged sword