Hedge funds features strong alignments of interest between aggressive institutional investors and managers and flexible investment mandates. Hedge fund investing is limited to institutional investors and individuals with high net worth due to the fact that the risks of hedge fund investments are inappropriate for many investors. The financial pool of wealth is continuously expanding. (Citibank, 2014) projected that hedge fund industry core assets of management (AUM) to increase to approximately $4.8 trillion toward 2018; and that approximately 74% of the assets will be accounted for by institutions. (Goldman Sachs, 2013) presented that the hedge fund has outperformed the majority of the traditional asset classes. This paper will present an overview of hedge funds and common hedge fund strategies in order to describe the hedge fund industry and to increase general knowledge of the hedge fund perspectives in the global markets.
Historians credit financial investor and journalist, Alfred Winslow with the establishment of the first hedge fund in 1949. Winslow’s equity market neutral hedge fund strategy was a long/short market position with leverage. The hedge fund began to gain popularity in the investor community in the mid 1960s. Since then, the progress of the financial market has been exponential as a result of the rapid evolution of technology and the progressive liberalization of the global markets. The heterogenous hedge fund industry players pursue a diversity of market investing strategies, across a diversity of asset classes, with an equally diverse range of financial instruments.
In modern times, hedge funds are characterized by high initial investment requirements and limited oversight by regulatory agencies. (Connor & LeSarte 2004) described the hedge fund as a “speculative investment vehicle that is designed to exploit the optimized information that is held by the fund’s managers. Tsatsaronis described the hedge fund as “a nimble and opportunistic investment vehicle that is well positioned for investor and principal to capitalize upon new opportunities that evolve with the growth of the markets. Further, the hedge fund is often classified as market directional or neutral; as directional funds are characterized by high correlation with the market and neutral funds have a low correlation with the markets.
Hedge funds constitute investment partnerships that are private and which engage in broad investment mandates. Hedge fund strategy themes include the long/short, relative value, tactical trading, and event driven approaches and hybrid, or multi-strategies (see table 1, Appendix A). Within a high pressure, high stakes trading environment, the hedge fund manager is expected to realize absolute return targets in any market. Therefore, in order to achieve absolute return targets, the hedge fund managers are given the authority to select from a diversity of asset classes and to use dynamic hedge fund trading strategies that may include short sales, derivatives and leverage. Figure 1 shows the diversity of the term structure of hedge fund stated portfolio liquidity based upon a 2010 report:
Figure 1. Hedge Fund Asset Liquidity in Financial Crisis Environment (Citibank, 2014)
The hedge funds may also be classified as discretionary or systematic. Systematic hedge fund strategies utilize complex computer based formulas; while discretionary strategies use decision making approaches that are based upon the judgement of the hedge fund manager (Connor & LaSarte, 2004). Based upon the work of Sharpe (1992), commercial software has been developed that provides for the analysis of asset allocation approaches and the portfolio “style mix (Fung & Hseih, 1997, p. 275).
The hedge fund trading strategy is comprised of the quantity, or leverage and the direction, whether long or short. The equity long-short is a common hedge fund strategy that encompasses stock purchases using leverage and short sales of less attractive picks within the same portfolio. Long/short hedge fund strategies “exploit the hedge fund managers’ ability to short equities freely; and separate the market risk from the individual stock risk” (Connor & LeSarte, 2004). Further, the equity long short hedge fund is characterized as bottom up; driven fundamentally; and investors that are not managed by benchmarks.The risk return profile for the equity long/short strategies is classified as medium volatility with medium returns; and high liquidity. Common long/short strategies include global diversified and emerging market long/short approach.
The long/short manager delivers alpha from the choice of stocks and by variations of the net beta exposure to the stocks. In turn, the outcomes of the alpha generation is higher correlations to the equity markets in markets that are rising. Conversely, the generation produces lower correlations in the falling markets. The long/short strategy empowers the manager to select either net-short or net-long beta market exposure
(Lamm, 2000) supported that long/short equity hedge funds historically have outperformed the traditional long equity exposure and with less risk as a result of long/short hedge fund manager generation of alpha through stock selection in the capital market. Figure 2 shows the alpha generation for hedge funds from 1995 to 2012 based upon the Dow Jones Credit Suisse Hedge Fund Index:
Figure 2. Hedge Fund Alpha Generation 1995 to 2012 (GSAM, 2013)
In juxtaposition to the static beta and the risk free, the alpha generation has been consistently strong for the period. However, maintaining the generation in the past few years has been challenging for equity long/short managers (GSAM, 2013).
The event driven hedge fund is characterized by trades based upon corporate events, to include mergers, bond upgrades, bankruptcies, spinoffs, stock buybacks and takeovers. The event may evolve from circumstances described as distressed in financial terms, which creates a onetime capitalization opportunity for hedge fund investors. The risk return profile for the event driven hedge fund strategy is classified as medium volatility with medium returns; and with medium liquidity. Common examples of the event driven hedge fund theme include merger arbitrage strategies; special scenarios; and high yield, distressed strategies. The primary risk for event driven strategies is credit risk.
The merger arbitrage strategy capitalizes upon the lower price of stocks that results from an acquisition that drives the price of the acquiring firm’s stock down and the price of the acquired firm up. (Collimore, 2016) described merger arbitrage funds as profit seekers through investments in firms that announce mergers or the intent to merge. The primary risk of merger arbitrage approaches lies in the potential for the merger to fail, which negates the potential value of the strategy. Here, the hedge fund manager shows faith in the future of the investment; and may take a long position unless it is perceived that the financial distress associated with the asset will increase.
The Convertible Arbitrage - Relative Value Strategy
The relative value hedge fund is characterized by an exploitation of associated asset mispricings or price convergences. The risk return profile for the relative value hedge fund strategy is classified as low volatility with low returns; and with medium liquidity. Common strategies include volatility trading; convertible arbitrage; and equity market neutral approaches. The risk profile for relative value strategies are systematic and the risk of volatility spikes.
The convertible arbitrage strategy encompasses the purchase of convertible securities while shorting the firm’s common stock. The portfolio is structured in a manner in which the short equities and corporate bonds are market neutral. As opposed to decreasing the exposure to risk, the long/short strategy increases the portfolio liquidity risk and expands the liquidity risk quantity. Batta, (Chacko & Dharan, 2010) presented that the convertible arbitrage is one of the oldest hedge fund strategies; but that the persistence and magnitude of convertible arbitrage performance has been perplexing. Further, the convertible arbitrage abnormal returns reflect compensation for the hedge fund manager’s increases to liquidity risk exposure.
The tactical trading hedge fund is characterized by directional exposures to currencies; commodities; equities; and interest rates. The risk return profile for the tactical trading hedge fund strategy is classified as high volatility with high returns; and high liquidity. Common strategies include price-based models, managed futures, and macro discretionary approaches. Tactical trading strategies are commonly directional and based upon the anticipation of global market trends; interest rates; and currency and commodities market activity. The high volatility profiles require higher expectations of performance from the hedge fund manager. The primary risks of tactical trading are trend reversals and high drawdown.
The market for hedge fund trading is high profile, highly competitive, and risky. Therefore, the long/short hedge fund manager may use a diversity of strategies that are based upon the selection of stock; geographic markets; and industry. Several hedge fund strategies have been employed by institutional investors that capitalize upon different aspects of the capital markets. Batta, (Chacko & Dharan, 2010) noted that hedge funds with long/short positions that are not carefully aligned with liquidity risk produce outcomes of high liquidity risk within the portfolio. Further, the equity long/short hedge fund strategies take long positions that are illiquid in comparison to the liquidity of short positions.
Overall, the hedge fund markets have been sustained through periods of economic disparities and uncertainty. (Citibank, 2014) supported that the Global Financial Crisis (GFC) significantly impacted the hedge fund markets; leaving institutional investors that are risk-averse as the predominant sources of capital. However, (Fung & Hseih, 1997) supported that hedge funds pursue strategies that are highly dynamic and that vary dramatically from traditional mutual funds. Conclusively, most market analysts agree that the hedge fund market will continue to expand and to endure the shocks of economic crisis.
Batta, G. Chacko, G. Dharan, B. A Liquidity-Based Explanation of Convertible Arbitrage Alphas. The Journal of Fixed Income, 2010.
Citibank. 2014. Opportunities and Challenges for Hedge Funds in the Coming Era of Optimization. Citi Investor Services. Retrieved from http://www.citibank.com/icg/global_markets/prime_finance/docs/Opportunities_and_Challenges_for_Hedge_
Collimore, T. 2016. Hedge Fund Strategies for Individual Investors. CFA Institute. Retrieved from https://www.cfainstitute.org/learning/investor/Documents/hedge_funds.pdf
Connor, G. Lesarte, T. 2004. An Introduction to Hedge Fund Strategies. International Asset Management Ltd. London School of Economics and Political Science.
Fung, W. Hseih, D. Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds. The Review of Financial Studies, 10(2), 275-302, 1997.
GSAM. 2013. The Case for Hedge Funds. Goldman Sachs. Retrieved from http://www.goldmansachs.com/gsam/institutions/ideas/insights/investment-insights/case_for_hedge_funds/case-for-hedge-funds.pdf
Lamm, R. The Role of Long/Short Equity Hedge Funds in Investment Portfolios. DB Absolute Returns Strategies Research, 2004.
Tsatsaronis, K. V. Special Feature: Hedge funds. BIS Quarterly Review, 61-71, 2000.
Hedge Fund Strategy Themes
Table 1. Major Hedge Fund Strategy Themes (GSAM, 2013)