Hedge fund strategies: equity, event-driven, relative value, opportunistic

How are hedge fund strategies grouped?

Hedge funds are classified by strategy, which helps investors pick a mix of funds, compare like with like and choose a benchmark. A common scheme has five families. The quick way to tell them apart is to ask where the bet comes from.

Hedge fund strategiesname the source of the bet

• Equity hedge Memorize bottom-up, long and short shares
  • Fundamental long/short Use it long cheap, short expensive; usually net long
  • Fundamental growth and value Know the idea long growth (or turnaround) names, short the opposite
  • Short biased Use it mostly short overvalued shares
  • Market neutral Use it longs and shorts balanced, beta near zero
• Event-driven Memorize profit from a corporate event
  • Merger arbitrage Memorize buy the target, short the acquirer in stock deals
  • Distressed/restructuring Use it debt or equity near or in bankruptcy
  • Special situations Know the idea spin-offs, buybacks, asset sales, rescue finance
  • Activist Memorize public shares plus pressure for change
• Relative value Memorize price gaps between related securities
  • Convertible bond arbitrage Memorize long the convertible, short the shares
  • Fixed income Know the idea rates, credit, MBS, asset-backed securities (ABS), high yield
  • Multi-strategy Know the idea capital moved across strategies
• Opportunistic Memorize macro and futures
  • Global macro Memorize top-down bets on economic trends
  • Managed futures (CTAs) Memorize trend and momentum models in futures
• Multi-manager Memorize a portfolio of managers
  • Fund of funds Know the idea invests in other hedge funds

What do equity hedge funds do?

Equity hedge funds trade shares and equity derivatives, mostly from the bottom up: company analysis first, then the industry, then the market. A top-down approach starts with the economy instead.

A fundamental long/short fund buys shares it thinks are undervalued and shorts those it thinks are overvalued. It usually keeps a net long position, so it still carries market risk. Within it, fundamental growth funds go long companies expected to grow fast and short those under pressure. Fundamental value funds go long unloved companies where a turnaround could lift revenue and cash flow. Both tend to end up long biased, so their returns carry a non-zero beta.

A short biased fund holds mainly short positions in overvalued shares, often after forensic accounting work that exposes hidden flaws. It can help in market stress but struggles when markets rise for years. A market neutral fund balances longs and shorts so that its beta is close to zero. It profits from the gap between good and bad stock picks rather than from the market. Because that gap is modest, market-neutral funds often use leverage, which raises risk when markets turn volatile.

Over a long sample, short-biased funds have been negatively correlated with equity-based strategies, while market-neutral funds show the lowest positive correlation with the market.

What do event-driven funds do?

Event-driven strategies are bottom-up and profit from defined events that change valuations, usually changes in corporate structure. They thrive in strong economies with plenty of corporate activity.

Merger arbitrage buys the target’s shares at a discount to the announced price and, in a stock deal, shorts the acquirer. The discount (the deal spread) exists because of timing and the chance that legal, regulatory or financing problems stop the deal. Shorting the acquirer also hedges against the buyer overpaying. The main risk is that the deal fails and the target’s price falls back. The gains are small and the losses large, so leverage is common, which magnifies the damage when a deal collapses.

Distressed/restructuring funds buy the securities of firms in or near bankruptcy, such as senior debt trading well below par, or debt expected to convert into equity in a restructuring (a fulcrum security). Special situations funds trade around catalysts: spin-offs, buybacks, special distributions, asset sales and rescue finance. An activist fund buys enough shares to seek a board seat and influence policy, for example asking for a sale of a division, higher payouts or new management. Unlike private equity, it works mainly in public equity markets.

Event-driven funds tend to be long biased, merger arbitrage the least. A merger takes about 6 to 24 months to complete, while a bankruptcy can take years.

How big is a merger arbitrage spread?

For a cash deal, the investor pays the target’s current price and receives the offer on closing.

$$S = \dfrac{O - P}{P}$$

Deals take months, so a spread is often quoted as an annual rate.

$$A = (1 + S)^{12/T} - 1$$

In a stock deal the target is paid in acquirer shares. The fund buys the target and shorts the acquirer in the exchange ratio, which fixes the spread whatever the acquirer’s price does.

$$D = e\,P_A - P_T$$

Here $D$ is the spread per target share in currency, $e$ the exchange ratio (acquirer shares per target share), $P_A$ the acquirer’s price and $P_T$ the target’s price.

Go deeper What chance of closing does the price imply?

At 46 against a 50 offer and a 38 fall-back, the gain is 4 and the loss is 8. The expected return is zero when $p \times 4 = (1 - p) \times 8$, so $p = 8 \div 12 = 2/3$. A price of 46 therefore implies about a two-thirds chance of closing, ignoring the time value of money. If you think the odds are better, the position is attractive.

What do relative value funds do?

Relative value strategies profit when a pricing gap between related securities closes, based on an unusual short-term relationship. They are built to limit net market and credit risk, but they often span several asset classes, not just one.

Convertible bond arbitrage exploits mispricing between a convertible bond and its parts, the straight bond and the embedded call option. The fund buys the convertible and sells short a number of the same issuer’s shares, set by the call option’s delta. It is sensitive to bankruptcy risk, which can be hedged with put options or credit default swaps. Fixed-income arbitrage looks for relative value among government bonds, corporate credit, asset-backed and mortgage-backed securities and high-yield debt. Multi-strategy funds trade relative value within and across asset classes, often through separate pods of managers, and move capital among them as conditions change.

What do opportunistic and multi-manager funds do?

Global macro funds take top-down positions in rates, currencies, equities and commodities on the basis of expected economic trends. They benefit from volatility, so heavy central bank intervention to smooth shocks can shrink their opportunities. Managed futures funds, also called commodity trading advisers (CTAs), trade futures in commodities, equities, bonds and currencies using models that follow trends and momentum. They can diversify a portfolio, especially in strong trends and long periods of market stress, but choppy, mean-reverting markets give false signals and can cause long drawdowns. As CTAs have moved into stock index and bond futures, their diversification benefit has become less reliable. Commodity-focused CTAs also face the price tension between suppliers and consumers: high prices cut demand and low prices cut supply.

A fund of funds is a multi-manager fund that invests in other hedge funds, which is covered in the next lesson.

Exam tip Name the source of the bet: a company, an event, a price gap or the economy.

Go deeper Why market-neutral funds need leverage

If longs and shorts are perfectly balanced, the market’s move cancels and only the difference in stock selection remains. That difference is often single digits per year. To turn it into a return worth paying fees for, managers borrow to scale up both sides. Leverage raises the risk of large losses when correlations jump or stocks move apart in unexpected ways.

Go deeper Convertible arbitrage and the delta

A convertible bond is worth a straight bond plus a call option on the issuer’s shares. The option’s delta tells how many shares the call behaves like. Shorting that many shares offsets small share price moves, leaving the fund to earn the bond’s coupon and any mispricing. Deltas change with the share price, so the hedge must be adjusted, which is a source of trading cost and risk.