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STRATEGY CATEGORIES FOR HEDGE FUNDS

-Jeet

R.Shah M.Com , CFP CM

INTRODUCTION
In order to compare performance, risk, and other characteristics, it is helpful to categorise hedge funds by their investment strategies. The hedge fund strategy classifications described here parallel the categories of Goldman Sachs and Financial Risk Management (FRM).

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INTRODUCTION

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Strategies may be designed to be market-neutral (very low correlation to the overall market) or directional (a bet anticipating a specific market movement). Selection decisions may be purely systematic (based upon computer models) or discretionary (ultimately based on a person). A hedge fund may pursue several strategies at the same time, internally allocating its assets proportionately across different strategies.

INTRODUCTION
Some hedge fund strategies (for example, fixed income arbitrage) were previously the proprietary domain of investment banks and their trading desks. One driver for the growth of hedge funds is the application of investment bank trading desk strategies to private investment vehicles.

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1. LONG/SHORT

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Long/short hedge funds focus on security selection to achieve absolute returns, while decreasing market risk exposure by offsetting short and long positions. Compared to a long-only portfolio, short selling reduces correlation with the market, provides additional leverage, and allows the manager to take advantage of overvalued as well as undervalued securities. Derivatives may also be used for either hedging or leverage. Security selection decisions may incorporate industry long/short (such as buy technology and short natural resources) or regional long/short (such as buy Latin America and short Eastern Europe).
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1. LONG/SHORT

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The classic long/short position is to choose two closely related securities, short the perceived overvalued one and long the undervalued one. For example, go long TATA Motors and short Maruti Suzuki. This classic example has the greatest risk reduction since the two stocks are likely to have very similar market risk exposures. Long/short portfolios are rarely completely market-neutral. They typically exhibit either a long bias or short bias, and so have a corresponding market exposure (positive or negative). They are also likely to be exposed to other market-wide sources of risk, such as style or industry risk factors.
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2. RELATIVE VALUE

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Relative value funds use market-neutral strategies that take advantage of perceived mispricing between related financial instruments. Fixed-income arbitrage may exploit short-term anomalies in bond attributes, such as the yield curve or the spread between Treasury and corporate bonds . It involves taking long and short positions in bonds & other interest-ratesensitive securities. These positions, when combined, approximate one another in terms of rate and maturity but for some reason are suffering from pricing inefficiencies. Risk varies with the types of trades & level of leverage employed. In the United States, this strategy often is implemented through mortgagebacked bonds and other mortgage derivative securities. This strategy has proven to be a very profitable but unpredictable one. Mortgage securities carry embedded options that are very difficult to value and even more difficult to hedge. Many managers have found attractive opportunities overseas, but typically they are reticent to disclose the specific nature of their trades. Portfolio disclosure in this strategy is often nonexistent..

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2. RELATIVE VALUE

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Convertible arbitrage profits from situations where convertible bonds are undervalued compared to the theoretical value of the underlying equity and pure bond. In these cases, the hedge fund manager takes long positions on the convertible bond & shorts the underlying stock thereby working the spread between the two types of securities.. Returns result from the difference between cash flows collected through coupon payments & short interest rebates and cash paid out to cover dividend payments on the short equity positions. Returns also can result from the convergence of valuations between the two securities. Risk originates from the widening of the valuation spreads due to rising interest rates or changes in investor preference. The focus of investments can be nation-specific or global in nature.
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2. RELATIVE VALUE
Statistical arbitrage involves exploiting price differences between stocks, bonds, and derivatives (options or futures) while diversifying away all or most market-wide risks. Situations for relative-value arbitrage often occur with illiquid assets, so there may be added liquidity risk. Gains on individual trades made be small, so leverage is often used with relative-value strategies to increase total returns.
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EQUITY MARKET-NEUTRAL STRATEGY PROFILE

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EQUITY MARKET-NEUTRAL RISK PROFILE

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3. EVENT DRIVEN

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Event-driven strategies exploit perceived mispricing of securities by anticipating events such as corporate mergers or bankruptcies, and their effects. Merger (or risk) arbitrage is the investment in both companies (the acquirer and takeover candidate) of an announced merger. Until the merger is completed, there is usually a difference between the takeover bid price and the current price of the takeover candidate, which reflects uncertainty about whether the merger will actually happen. A fund manager may buy the takeover candidate, short stock of the acquirer, and expect the prices of the two companies to converge. There may be substantial risk that the merger will fail to occur. Bankruptcy and financial distress are also hedge fund trading opportunities, because managers in traditional pooled vehicles (such as mutual funds and pension funds) may be forced to avoid distressed securities, which drive their values below their true worth. Hedge fund managers may also invest in Regulation D securities, which are privately placed by small companies seeking capital, and not accessible to many traditionally managed funds.

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CORPORATE LIFE CYCLE

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3A.MERGER ARBITRAGE EXAMPLE.

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POTENTIAL RISKS IN MERGER ARBITRAGE.

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MERGER (RISK) ARBITRAGE RISK PROFILE

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3B. INVESTING IN DISTRESSED SECURITIES

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3B. INVESTING IN DISTRESSED SECURITIES

Distressed securities hedge funds invest specifically in the securities of companies that are experiencing financial or operational difficulties. The term distressed securities refers to a wide range of financial claims on firms that either have filed for bankruptcy protection or are trying to avoid bankruptcy by negotiating an out-of-court restructuring with their creditors. The recovery process of distressed companies generally involves several major steps, and distressed securities managers may focus on specific areas in this process by extracting value when a catalyst or an event that changes the price of the securities of the distressed companies occurs.

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3B. INVESTING IN DISTRESSED SECURITIES

Hedge fund managers who specialize in distressed securities blend a specialized knowledge of the bankruptcy process with fundamental analysis of distressed companies and the intrinsic value of their debt securities and equities that allows them to predict, and when necessary take actions to influence, the outcome of the bankruptcies and reorganizations. Distressed securities managers typically invest long and short in the securities of companies undergoing bankruptcy or reorganization. They tend to focus on companies that are undergoing financial rather than operational distressin other words, good companies with bad balance sheets. Overleveraged companies that cannot cover their debt burden become oversold when institutional bondholders liquidate their holdings; as a result, as the companies enter bankruptcy, distressed securities managers buy the positions at pennies on the dollar.

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3B. INVESTING IN DISTRESSED SECURITIES

Often the securities of these companies trade below their inherent value because of the uncertainty of the companies future. Furthermore, traditional investors often are restricted from owning the securities of companies with very low credit ratings. As a result, hedge fund managers often can buy securities of sound companies with real assets that have not, for a variety of technical reasons, been able to access the capital markets and deleverage their balance sheets. Managers then look for the instruments to appreciate or be exchanged for higher-valued securities at various points as the company works its way through the restructuring process. Some fund managers also hedge their portfolio by selling short the securities of companies they believe will not restructure successfully and head toward bankruptcy, as well as those that will not emerge from bankruptcy.

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3B. INVESTING IN DISTRESSED SECURITIES

Distressed managers usually concentrate on certain sectors and investing styles that fit their own expertise. Aspects that differentiate distressed investing styles include the type of claim instrument invested in (i.e., bank debt, corporate debt, trade claims, and equities), the phase of the bankruptcy process, and the exit strategy used.

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3B. INVESTING IN DISTRESSED SECURITIES- TWO BROAD STRATEGIES

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3B. INVESTING IN DISTRESSED SECURITIES SKILLS REQUIRED

Valuing assets, including locating, collecting, and analyzing information Negotiating and bargaining Understanding the firms capital structure as well as the legal rights and financial interests of all other claimholders Risk management, including a thorough understanding of the specific risks associated with investing in distressed situations

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3B. DISTRESSED INVESTING STRATEGY PROFILE.

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2008-09 !!!!!!!!!!!!

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3B. DISTRESSED INVESTING RISK PROFILE.

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4. TACTICAL TRADING
The tactical trading classification includes a large variety of directional strategies, including the subcategories of global macro and commodity trading advisers (CTAs). Global macro funds make investments based upon appraisals of international conditions, such as interest rates, currency exchange rates, inflation, unemployment, industrial production, foreign trade, and political stability. The global macro subcategory tends to contain the largest hedge funds, such as Robertsons Tiger Fund and Soros Quantum Fund, and they receive the most scrutiny when hedge funds are accused of undermining global stability.

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4. TACTICAL TRADING
Global macro traders may use leverage, short sales, or derivatives to maximise returns. Some funds specialise in illiquid assets in emerging markets, which sometimes have financial markets that do not allow short sales or do not offer derivatives on their securities. Commodities trading advisers (CTAs) specialise in speculative trading in futures markets.

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4. TACTICAL TRADING

Jeet R.Shah

Trades may involve futures on precious metals, currencies, financial instruments, or more typical commodities in futures exchanges throughout the world. CTAs often use computer models to profit from differences in contract selection, weighting, and expiration. Fung and Hsieh (2001) explain trendfollowing, the strategy of a majority of CTAs, and how the strategy can show positive returns, especially in extreme markets. In the U.S., the Commodity Futures Trading Commission (CFTC), not the SEC, regulates the actions of CTAs.

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GLOBAL MACRO STRATEGY OVERVIEW

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MANAGED FUTURES- DEFINED

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MANAGED FUTURES PROFIT IN BOTH UP AND DOWN MARKETS

Managed futures investors participate in this speculative trading by investing with a CTA. Although hedge funds that engage in futures trading are considered to be managed futures investors, they differ from private pools and public funds in that futures are not the core of their strategy, rather are a single component of a synthesis of instruments. Managed futures portfolios can be structured for a single investor or for a group of investors. Portfolios that cater to a single investor are known as individually managed accounts. Typically these accounts are structured for institutions and high-net-worth individuals. As mentioned, managed futures portfolios that are structured for a group of investors are referred to as either private commodity pools or public commodity funds. Public funds, often run by leading brokerage firms, are offered to retail clients and often carry lower investment minimums combined with 31 higher fees. Private pools are the more popular structure for group investors.

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MANAGED FUTURES
Like individually managed accounts, they attract institutional and high-net-worth capital. Private pools in the United States tend to be structured as limited partnerships where the general partner is a commodity pool operator (CPO) and serves as the sponsor/salesperson for the fund. In addition to selecting the CTA(s) to actively manage the portfolio, the CPO is responsible for monitoring their performance and determining compliance with the pools policy statement.

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ADVANTAGES OF MANAGED FUTURES INVESTING

Low to negative correlation to equities and other hedge funds Negative correlation to equities and hedge funds during periods of poor performance Diversified opportunities, in both markets and manager styles Substantial market liquidity Transparency of positions and profits/losses Multilayer level of regulatory oversight
Disadvantages A high degree of volatility High fees A low level of advisor attention

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According to CTAs who use global futures and options markets as an investment medium, managed futures investing differs from hedge fund and mutual fund investing in a number of fundamental ways, including transparency, liquidity, regulatory oversight, and the use of exchanges.

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DHANAYAWAAD
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