To form a hedge fund, managers usually get their start by achieving a successful investing track record throughout years of industry experience. This is how they attract their first clients and build out their funds. But even with the requisite experience, an overall vision for your fund is inevitable, where you express an idea of how it will generate returns for investors. There are different hedge fund strategies to which you can refer.
1. Long/Short Equity Strategy
With this type of Hedge Fund Strategy, Investment manager maintains long and short positions in equity and equity derivative securities. Subsequently, the fund manager will buy the undervalued stocks and simultaneously sell those which are overvalued. In order to come up with an investment decision, it is necessary to adopt both quantitative and fundamental techniques.
Such a hedge fund strategy can be broadly diversified or narrowly focused on specific sectors. Basically, the fund goes long and short in two competing companies in the same industry. It can range broadly in terms of exposure, leverage, holding period, concentrations of market capitalization and valuations.
If Tata Motors looks cheap relative to Hyundai, a trader might buy $100,000 worth of Tata Motors and short an equal value of Hyundai shares. The net market exposure is zero in such case. But if Tata Motors does outperform Hyundai, the investor will make money no matter what happens to the overall market.
Suppose Hyundai rises 20% and Tata Motors rises 27%; the trader sells Tata Motors for $127,000, covers the Hyundai short for $120,000 and pockets $7,000. If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for $77,000, covers the Hyundai short for $70,000, and still pockets $7,000. If the trader is wrong and Hyundai outperforms Tata Motors, however, he will lose money.
2. Market Neutral Strategy
With this strategy, hedge funds target zero net-market exposure which assumes that shorts and longs have equal market value. In this circumstance, the entire return is generated from stock selection.
This strategy has a lower risk than the first strategy that we discussed, yet the expected returns are also lower.
A fund manager may go long in the 10 biotech stocks that are expected to outperform and short the 10 biotech stocks that may underperform. Therefore, in such a case the gains and losses will offset each other despite how the actual market does. So even if the sector moves in any direction the gain on the long stock is offset by a loss on the short.
The consulting services of investment banking include two main areas:
- Underwriting – Investments bankers raise capital, usually via the IPO process (selling stocks or bonds to an investor) on behalf of corporations.
- Mergers & Acquisitions (M&A) – Advisory roles for both buyers and sellers of businesses, managing the M&A process start to finish.
3. Merger Arbitrage Strategy
In this hedge fund strategy, the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. The fund will gain profit based on the basis: When the target company’s stock will sell at a discount to the price that the combined entity will have when the merger is done. This difference is the arbitrage profit. The merger arbitrageurs care only about the probability of the deal being approved and the time it will take to close the deal.
This particular hedge fund strategy looks at the risk that the merger deal will not close on time, or at all.
Consider these two companies– ABC Co. and XYZ Co.
Suppose ABC Co is trading at $20 per share when XYZ Co. comes along and bids $30 per share which is a 25% premium.
The stock of ABC will jump up, but will soon settle at some price which is higher than $20 and less than $30 until the takeover deal is closed.
Let’s say that the deal is expected to close at $30 and ABC stock is trading at $27.
To seize this price-gap opportunity, a risk arbitrageur would purchase ABC at $28, pay a commission, hold on to the shares, and eventually sell them for the agreed $30 acquisition price once the merger is closed.
Thus the arbitrageur makes a profit of $2 per share, or a 4% gain, less the trading fees.
4. Convertible Arbitrage
Convertibles generally are the hybrid securities including a combination of a bond with an equity option. A convertible arbitrage hedge fund typically includes long convertible bonds and short a proportion of the shares into which they convert. In simple terms it includes a long position on bonds and short position on common stock or shares. It attempts to exploit profits when there is a pricing error made in the conversion factor i.e. it aims to capitalize on mispricing between a convertible bond and its underlying stock. If the convertible bond is cheap or if it is undervalued relative to the underlying stock, the arbitrageur will take a long position in the convertible bond and a short position in the stock. On the other hand, if the convertible bond is overpriced relative to the underlying stock, the arbitrageur will take a short position in the convertible bond and a long position in the underlying stock.
Convertible arbitrage generally thrives on volatility.
Visions Co. decides to issue a 1-year bond that has a 5% coupon rate. So on the first day of trading it has a par value of $1,000 and if you held it to maturity (1 year) you will have collected $50 of interest.The bond is convertible to 50 shares of Vision’s common shares whenever the bondholder desires to get them converted. The stock price at that time was $20.
If Vision’s stock price rises to $25 then the convertible bondholder could exercise their conversion privilege. They can now receive 50 shares of Vision’s stock.
50 shares at $25 is worth $1250. So if the convertible bondholder bought the bond at issue ($1000), they have now made the profit of $250. If instead they decide that they want to sell the bond, they could command $1250 for the bond.
But what if the stock price drops to $15? The conversion comes to $750 ($15 *50). If this happens you could simply never exercise your right to convert to common shares. You can then collect the coupon payments and your original principal at maturity.
5. Capital Structure Arbitrage
This is a strategy used by many directional, quantitative and market neutral credit hedge funds, where they purchase a firm’s undervalued security and sell the overvalued security. It includes going long in one security in a company’s capital structure while at the same time going short in another security in that same company’s capital structure.
A news of particular company performing badly, which heavily decrease the company’s bond and stock prices. An intelligent fund manager will take advantage of the fact that the stocks will become comparatively much cheaper than the bonds.
Event-driven is the adoption of equity-oriented strategies involving investments, long or short, in the securities of corporations undergoing significant change such as spin-offs, mergers, liquidations, bankruptcies and other corporate events. Substantial profits may be generated by managers who correctly analyze the impact of the anticipated corporate event, predict the course of restructuring and take positions accordingly. Depending on the nature of the corporate event, either relative value or directional positions will be taken. Event-driven strategies are therefore intimately linked to the level of corporate activity.
In this type of strategy, the hedge funds buy the debt of companies that are in financial distress or have already filed for bankruptcy.
If the company has yet not filed for bankruptcy, the manager may sell short equity, betting the shares will fall when it does file.
7. Fixed-Income Arbitrage
Hedge funds that engage in fixed-income arbitrage eke out returns from risk-free government bonds, eliminating credit risk. Managers make leveraged bets on how the shape of the yield curve will change. For example, if they expect long rates to rise relative to short rates, they will sell short long-dated bonds or bond futures and buy short-dated securities or interest rate futures.
These funds typically use high leverage to boost what would otherwise be modest returns. By definition, leverage increases the risk of loss when the manager is wrong.
8. Global Macro
This is when the fund bases its holdings primarily on the overall economic and political views of various countries or their macroeconomic principles. Holdings may include long and short positions in various equity, fixed income, currency, commodities, and futures markets.
If a manager believes the United States is headed into a recession, he may short sell stocks and futures contracts on major U.S. indices or the U.S. dollar. He may also see a big opportunity for growth in Singapore, taking long positions in that country’s assets.
9. Short Only
The ultimate directional traders are short-only hedge funds – the professional pessimists who devote their energy to finding overvalued stocks. They scour financial statement footnotes and talk to suppliers or competitors to unearth any signs of trouble possibly ignored by investors. Occasionally, managers score a home run when they uncover accounting fraud or some other malfeasance.
Short-only funds can provide a portfolio hedge against bear markets, but they are not for the faint of heart. Managers face a permanent handicap: They must overcome the long-term upward bias in the equity market.
Depending on your ability to properly apply hedge fund strategies, you can generate amazing compounded annual returns for your investors. In reality, Equity Strategy is applied by the majority of hedge funds, followed by Relative Value or Macro Strategy and Event-Driven Strategy. By tracking the markets, investing and learning continuously, you can master these hedge fund strategies. And if you are curious about the process of forming a hedge fund, check out “How to start a new hedge fund”.