[Source - Hedge Fund Strategies - Barclay T. Lien, Kathryn M Kaminski and Mila Gemansky Sherman]
1. Introduction
2. In addition to high fee levels, the complex offering memorandam documentation needs to be understood by investors.
3. Some hedge funds strategies may have higher portfolio diversification benefits, while other may simply be return enhancers rather than true portfolio diversifiers.
4. Liquid Alts - which are mutual fund, closed-end fund, and ETF type vechicles that invest in various hedge fund-like strategies.
5. Liquid Alts - Empirical enidence shows that liquid alts significantly underperform similar hedge funds, which suggest that traditional hedge funds may be benefiting from an illquidity premium phenomenon that cannot be easily transported into a mutual fund format.
2. Classification of Hedge Fund And Strategies
6. Liquid Alts offer daily liquidity and are probhitied from charging incentive fees.
7. The Fund prospectus (offering memorandum) will specify the hedge fund's mandate and objectives and will include constraints, use of leverage shorting and derivatives.
3. Equity Strategies
8. Long/Short Equity
- The objective of long/short equity strategies is to be flexible in finding attractive opportunities on both the long and short sides of the market and to size them within a portfolio.
- Depending on their specific mandates, long/short equity strategies can shift between industry sectors (e.g. from tech to consumer goods), factors (e.g from value to growth) and geographic regions (e.g from Europe to Asia)
- L/S Equity is one of the most prevelant hedge fund strategies. It accounts for about 30% of all hedge funds.
- L/S Equity - Some managers use index-based shor hedges to reduce market risk, but most search for single-name shorts for portfolio alpha and added absolute return
- L/E Equity - This strategy can be handeled by both a limited partner and mutual fund-type vechicles.
9. Dedicated Short Selling and Short-Biased
- Both strategies aim to create an uncorrelated or negatively correlated source of return by seeking failing business models, corporate mismanagement, or other factors that may sour the market's perception of a given equity.
- uptick rule - states that when a stock decreases by 10% or more from its prior closing price, a short sale can be executed only at a price higher than the current (i.e. highest) bid. This means stock price must be rising to execute a short sale.
- Attractiveness - liquid, negatively correlated alpha to that of most other strategies, with mark-to-market pricing from public prices. Historic returns have been lumpy and generally disappointing
- Altman Z-score for judging companys bankruptcy fradulent and Beneish M-score for identifying potentially fradulent financial statements
- Managers search for, among other factors, inherently flawed business models, unsustainable levels of corporate leverage, and indications of poor corporate governance and/or accounting gimmickry.
10. Equity Market Neutral
- EMN managers neutralize market risk by constructing their portfolio such that the expected portfolio beta is approximately equal to zero
- The condition of zero market beat can also be achived with use of derivatives, including stock index futures and options
- The main source of skill of an EMN manager is in security selection.
- As many beta risks (e.g. market, sector) are hedged away, it is generally deemed acceptable for EMN manager to apply higher levels of leverage while striving for meaningful return targets.
11. Event-Driven Strategies
- Soft-catalyst event-driven approach - An event-driven approach in which investments are made proactively in anticipation of a corporate event that has yet to occur
- Hard-catalyst event-driven approach - Ab event-driven approach in which investments are made in reaction to an already announced corporate event in which security prices related to the event have yet to fully converge
- The payoff profile of the merger arbitrage strategy resembles that of a riskless bond and short put option
- The merger arbitrage investor can be viewed as owing an additionl call option the becomes valuable if/when another acquirer (i.e white knight) makes a higher bid for the targer company before the initial merger proposal is completed
- Because cross-border merger and acquisition (M&A) usually involves two sets of government approvals and M&A deals involving vertical integration often face anti-trust scrutiny these situations carry higher risks and offer wider maeger spread returns
12. Distressed Securities
- Hedge fund manager find inefficiently priced securities before, during, or after the bankruptcy process, but typically they will be looking to realize their returns somewhat faster than the longer-term orientation of private equity firms.
- Managers that invest in some distressed soverign debt often must face long time horizons to collect their payouts
- Valuations of distressed securites with little or no liquidity (e.g. those deemed Level 3 assets for US accounting purposes) are subject to smotthing effect of "mark-to-model" price discrimination.
- The bankruptcy process typically results in one or tow outcomes - liquidation or firm re-organization
- Sequence of payoff in liquidation - Senior secured debt, Junior secured debt, convertible debt, preferred stock and finally common stock
- Returns tend be be "lumpy" and somewhat cyclical. Distressed investing is particularly attractive in the early stages of an economic recovery after a period of market discolation.
- The return profile for distressed securities investing is typically at the higher end of event-driven strategies but with more variability
- Fulcrum Securities - Partially-in-the-money claims (not expected to be repaid) whose holders end up owing the reorganized company in a corporate reorganization suitation,
13. Relative Value Strategies
14. Merger Arb Strategies
- Merger Arb Strategy is relatively liquid strategy with defined gains from idosyncratic single security takeover suitations but occasional downside shocks when merger deals unexpectdetly fail
15. Managed Futures
- Managed futures, which gained its first major academic backing in a clasic paper by John Lintner in 1983
- Managed futures demonstrated natural positive skewness that has been useful in balancing negatively-skewed strategies
16. Multi-Manager Strategies
16.
- Studies have shown that multistrategy funds have generally outperformed FoF
17. When we add a 20% allocation to most hedge fund strategies to a traditional portfolio, the general result is the following :
- Totoal portfolio standard deviation decreases
- Sharpe ratio increases
- Sortino raio increases
- Maximum drawdown decreases in approximately one-third of portfolios