Tag Archives: Hedge Fund

Hedge Fund Trading Styles and Strategies Uncovered

There are four broad styles of hedge funds and multiple strategies beneath each style which are discussed at length in the book Hedge Funds Demystified by Scott Frush. This article summarises the four broad hedge fund styles and provides an insight into the management of hedge funds.

In many cases, Hedge Fund managers combine strategies from the styles below but regardless of the strategy, each has the aim of generating attractive absolute returns. This is the fundamental difference between most investing funds (eg mutual funds) and hedge funds; hedge funds aim to deliver absolute returns in both a bull and a bear market.

The following are the primary strategies employed by hedge funds (such as the infamous Long Term Capital Management Fund), grouped by style:

Tactical (also known as directional)

  1. Macrocentric – Strategy where the hedge fund manager invests in securities that capitalise on domestic and global market opportunities. Trading strategies are generally systematic or discretionary; systematic traders tend to use price and market-specific information (often based on technical trading rules) to make trading decisions, while discretionary managers use a judgmental approach regarding differences between current financial market valuations and what is perceived as the ‘correct’ or fundamental valuation.
  2. Managed futures - Strategy where the hedge fund manager invests in commodities derivatives with a momentum focus, hoping to ride the trend to attractive profits.
  3. Long/short equity - Strategy where the hedge fund manager combines long holdings of securities that are expected to increase in price with short sales of securities that are expected to decrease in price. Long/short portfolios are directional – that is, the investment strategy is based on the manager’s expectation of future movements in the overall market – and may be net long or net short. Short positions are expected to add to the return of the portfolio, but may also act as a partial hedge against market risk. However, long/short portfolios tend to be quite heavily concentrated and thus the effectiveness of the short positions as a hedge against market risk may be limited.
  4. Sector-specific – Strategy where the hedge fund manager invests in markets in specific sectors by going long, short, or both.
  5. Emerging markets – Strategy where the hedge fund manager invests in less developed, but emerging markets.
  6. Market timing – Strategy where the hedge fund manager either times mutual fund buys and sells or invests in asset classes that are forecast to perform well in the short term.
  7. Selling short – Strategy where the hedge fund manager sells short borrowed securities with the aim of buying them back in the future at lower prices thus making a profit.

Relative value (also called arbitrage)

  1. Convertible arbitrage - Strategy where the hedge fund manager takes advantage of perceived price inequality with convertible bonds and the associated equity securities.
  2. Fixed-income arbitrage - Strategy where the hedge fund manager purchases a fixed-income security and immediately sells short another fixed-income security to minimize market risk and profit from changing price spreads. This was one of the key strategies employed by Long Term Capital Management before its demise. This is known as a non-directional spread trade. Managers take equal long and short positions in two related securities when their prices diverge from their typical relationship. Positive returns are generated when the prices of the two securities re-converge. Because arbitrage opportunities can be limited and the returns from these trades tend to be quite small, arbitrage strategies often employ higher leverage than other funds in an attempt to maximise the profit from exploiting these perceived mis-pricings.
  3. Equity-market-neutral - Strategy where the hedge fund manager buys an equity security and sells short a related equity index to offset market risk. An example of this would be buying Coke stock and selling Pepsi short. Market neutral managers attempt to eliminate market risk by constructing portfolios of long and short positions which, when added together, will be largely unaffected by movements in the overall market. Positive returns are generated when the securities which are held long outperform the securities which are held short. Market neutral portfolios tend to be more heavily leveraged than the long/short directional portfolios discussed above.

Event-driven

Event-driven strategies seek to take advantage of opportunities created by significant corporate transactions such as mergers and takeovers. A typical event-driven strategy involves purchasing securities of the target firm and shorting securities of the acquiring firm in an announced or expected takeover. Profits from event-driven strategies depend on the manager’s success in predicting the outcome and timing of the corporate event. Event-driven managers do not rely on market direction for results; however, major market declines, which might cause corporate transactions to be repriced or unfinished, may have a negative impact on the strategy.

  1. Distressed securities - Strategy where the hedge fund manager invests in the equity or debt of struggling companies at steep discounts to estimated values.
  2. Reasonable value – Strategy where the hedge fund manager invests in securities that are selling at discounts to their estimated values as a result of being out of favor or being relatively unknown in the investment community.
  3. Merger arbitrage - Strategy where the hedge fund manager invests in merger-related situations where there are unique opportunities for profit.
  4. Opportunistic events - Strategy where the hedge fund manager invests in securities given short-term event-driven situations considered to offer temporary profitable opportunities. An example of this may be if a piece of legislation is about to change and particular companies are likely to benefit.

Hybrid

  1. Multistrategy - Strategy where the hedge fund manager employs two or more of the above strategies at one time. Managers may elect to employ a multi-strategy approach in order to better diversify their portfolio or to avoid constraints on their investment opportunities.
  2. Funds of funds - Strategy where the hedge fund manager invests in two or more stand-alone hedge funds rather than directly investing in securities.
  3. Values-based - Strategy where the hedge fund manager invests according to certain personal values and principles.

The Collapse of Long Term Capital Management; Hedge Funds and Leverage

After watching a short excerpt of a Warren Buffet speech, I thought I may quickly summarise the collapse of the famous Hedge Fund, Long Term Capital Management. But First, Watch this excerpt, it is both funny and informative.

I have sourced most of the information below from an excellent paper done by Gregory Connor and Mason Woo (LSE) called An Introduction to Hedge Funds. I will separately write an introduction to Hedge Fund Strategies article after this article to have a more detailed look at Hedge Funds.

Long Term Capital Management

During the late 90’s, the largest tremor through the hedge fund industry was the collapse of the hedge fund Long-Term Capital Management (LTCM). LTCM was the premier quantitative-strategy hedge fund, and its managing partners came from the very top tier of Wall Street and academia. These funds are commonly known as “quant funds” or quantum funds and they typically use ma thematic strategies based on past market performance to predict future performance. They are typically very short term and are capable of providing very high returns.

From 1995-1997, LTCM had an annual average return of 33.7% after fees. At the start of 1998, LTCM had $4.8 billion in capital and positions totalling $120 billion on its balance sheet [Eichengreen, 1999].

Long Term Capital Management Strategy and Leverage ratio

LTCM largely (although not exclusively) used relative value strategies, involving global fixed income arbitrage and equity index futures arbitrage. As an example, LTCM exploited small interest rates spreads, some less than a dozen basis points, between debt securities across countries within the European Monetary System. Since European exchange rates were tied together, LTCM counted on the reconvergence of the
associated interest rates.

Its techniques were designed to pay off many sets of small returns, with extremely low volatility. To achieve a higher return from these small price discrepancies, LTCM employed very high leverage. Before its collapse LTCM controlled $120 billion in positions with $4.8 billion in capital. In terms of calculating this leverage, this represented an extremely high leverage ratio (120/4.8 = 25). Banks were willing to extend almost limitless credit to LTCM at very low interest rates, because the banks thought that LTCM had latched onto a certain way to make money.

LTCM was not an isolated example of size-able leverage. At that time, more than 10 hedge funds with assets under management of over $100 million were using leverage at least ten times over [President’s Working Group, 1999].


The Collapse of Long Term Capital Management

In the summer of 1998, the Russian debt crisis caused global interest rate anomalies. All over the world, fixed income investors sought the safe haven of high quality debt. Spreads between government debt and risky debt unexpectedly widened in almost all the LTCM trades.

LTCM lost 90% of its value and experienced a severe liquidity crisis. It could not sell billions in illiquid assets at fair prices, nor could it find more capital to maintain its positions until volatility decreased and interest rate credit spreads returned to normal.

Emergency credit had to be arranged to avoid bankruptcy, the default of billions of dollars of loans, and the possible destabilisation of global financial markets. Over the weekend of September 19-20, 1998, the Federal Reserve Bank of New York brought together 14 banks and investment houses with LTCM and carefully bailed out LTCM by extending additional credit in exchange for the orderly liquidation of LTCM’s holdings.

This bail out of Long Term Capital Management is similar to the recent bail out by the New York Federal Reserve of Bear Sterns. I will not go into whether or not one was more justified than the other but I read an excellent article Brave New Fed which is worth reading if you are interested.

Since the collapse of LTCM, hedge fund leverage ratios have fallen substantially.The aftermath of the Russian debt crisis and LTCM debacle temporarily stalled the growth of the hedge fund industry. In 1998, more hedge funds died and fewer were created than in any other year in the 1990s [Liang, 2001].

The number of hedge funds as well as assets under management (AUM) declined slightly in 1998 and the first half of 1999. After that the growth of hedge funds resumed with no major changes to regulations but with guidelines for additional risk management. [Lhabitant, 2002; Financial Stability Forum, 2000].

To see an excellent written summary of the Warren Buffest speech, see Warren Buffett on long term Value Investing or to see another Warren Buffett Video, click here.