Alternative investments: Hedge Funds
As an investor we all aim for higher returns on our investment, and hedge funds are a form of alternative investment that may help us to achieve our investing goals. However, the terminology and strategies used by hedge fund managers can be baffling.
Hedge fund managers' strategies tend to focus on an asset class, a particular geography, currencies, fixed income, or a mix of them. These are some of the most commonly used ones.
Long/short was the first strategy used in hedge funds. It is a low risk strategy where the hedge fund manager buys -or goes long on- strong securities and sells -or shorts- the weaker ones. This strategy focuses on buying an undervalued stock and selling an overvalued stock to make profits. The varied forms of this strategy would be "long only", "short only", "short bias", "long bias" or variable bias strategies that are adopted by fund managers based on the market movements. This strategy is also used for fixed income securities.
The risk involved here is making a wrong bet. That is when the expected stronger stocks decline and expected weaker stocks performs well.
This strategy is an extension of the long/short strategy. For example, a hedge fund takes a $10 million long position in DBS bank and a $10 million short position in OCBC bank, both belonging to banking industry. With these positions, any event that causes all banking stocks to fall will lead to a loss on the DBS position and a profit on the OCBC position. Similarly, an event that causes both stocks to rise will have little effect, since the positions balance each other out. So, the market risk is minimal. This position would be taken when a hedge fund believes that DBS will perform better than OCBC.
The risk here lies in the volatility in the market, which makes it difficult to maintain a truly neutral fund due to changing correlations of the different market segments.
Arbitrage strategies are applied to convertible securities to take advantage of the apparent mispricing between related financial assets.
For example in a convertible arbitrage strategy, a hedge fund buys a particular company’s convertible stock and shorts the stock of the company. Now if the stock price of the company falls, the hedge fund will gain from its short position as it is quite likely that the decline in bonds would be less than the decline in stocks. On the other hand, if the stock price rises, the hedge fund can convert its convertible bonds into stock and sell that stock at market value, thereby earning from its long position, while compensating for any losses on its short position.
Other varied forms of this strategy includes "quantitative strategy", "equity arbitrage", "relative", "value strategy", and "convertible arbitrage".
Lower liquidity, a mismatch of the time frame for conversion, or the occurance of unpredictable events such as a market crash adds to the risk of this particular strategy.
This strategy seeks to gain from the pricing inefficiencies that occur before or after a corporate event. Events that are targeted include corporate restructuring, stock buybacks, bond upgrades, earnings surprises, and spin-offs, which have an impact in the short term.
Suppose, there is news of a potential acquisition. In that scenario, the stock price of the company to be acquired rises but remains below the acquisition price, given the uncertainty that the acquisition may or may not occur.
Also known as "special situation" or "special opportunity", these strategies have two sub-divisions:
Distressed investing &
Risk or merger arbitrage.
Distressed securities strategy focuses on the companies experiencing financial difficulties. On the other hand, Merger/risk arbitrage strategy focuses on companies which are involved in mergers and takeovers, both of the acquiring company and the takeover target.
The risk here is that corporate events do not happen as planned so this can ultimately reduce the stock price of a company and result in losses.
Emerging Economies Strategy
This strategy focuses on emerging economies. These economies are attractive as they are transiting from a closed to an open economy and start being noticed globally due to their pace of growth.
The risk involved is that these economies are not stable, as they are in transition. Disruption in growth is possible, due to political instability, or domestic revolts forcing local governments to backtrack on the reforms they promised.
This strategy spreads the risk of investments over a number of countries in the world. Macroeconomic indicators and geopolitical trends are used to take a position.
For example, macro hedge funds often invested in the yen carry trade. That meant that the fund borrowed Japanese yen, and took advantage of extremely low interest rates in Japan to invest the proceeds in dollar denominated assets such as Treasury bills, which had higher yields. As long as the yen did not appreciate, the strategy provided substantial payoffs.
Unexpected macro-economic news, central bank policy actions, political risk, and information asymmetry are some of the risks that affects this strategy.
As an investor, it is necessary to understand the strategy of a hedge fund before making any investment. A well understood strategy will help you to assess risk appropriately especially when hedge funds use "multi-strategy", wherein they engage in different investment strategies to earn profits.