Hedge Fund Strategies

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  • Hedge Funds

  • AgendaHedge Funds an OverviewType of Hedge FundsHedge Funds StrategiesEquity Long/ShortDistress SecuritiesConvertible ArbitrageFixed Income ArbitrageGlobal MacroMerger Arbitrage

  • Hedge Funds Strategies

  • Hedge fund strategy-Categories

  • Relative Value strategiesTake advantage of relative pricing discrepancies between instruments such as equities, debt, options and futures. Managers may use mathematical, fundamental, or technical analysis to arrive at valuation differences. Securities may be mispriced relative to the underlying security, related securities, groups of securities or overall market. Many hedge funds in this category use leverage and seek opportunities globally.

  • Event Driven strategies

    Investing in opportunities created by significant corporate events, such as mergers and acquisitions, bankruptcy reorganisations and share buybacks.Leverage may be used by some managers to increase the exposure to an investment. Fund managers may hedge against downside market risk by using derivative strategies such as purchasing put options or put option spreads.

  • Directional strategies

    Buying and/or selling a security or financial instrument believed to be significantly under-priced or over-priced by the market, relative to its potential value.This discipline may concentrate on a specific company, industry or country. The strategy most familiar to investors is the long/short (hedged equity) strategy, which typically involves a core holding of equities which the manager owns (long positions) hedged at all times with short positions (sale of equities borrowed, not owned) giving the portfolio an overall long or short exposure.

  • Directional StrategyEquity Long/ Short

  • Define- Equity Long/ShortLong/short equity is an investment strategy, which earns return from stock picking, and isolates the risk (as well as the return) of a particular stock from the risk/return of the broader market or industry of which it is a part. The trade would involve purchasing the shares in one of the companies (going long) and selling the competitor short.

  • Strategy OverviewPicking stocks which are sufficiently balanced to keep the portfolio buffered from a severe market swing.Baskets of long and short investments are beta neutral.Market-neutral long/short equity trading balance their longs and shorts in the same sector or industry.The key to the success of this strategy is the fund managers ability to select a basket of long stocks that will perform better than the basket of shorts.Quantitative analysis is the most common method for identifying optimal long and short positions, some hedge fund managers rely on fundamental analysis, systematically analyzing industries and companies to find those on the brink of positive, or negative, change.

  • Strategy Overview- Contd.One strategy known as "pairs trading" matches its long and short investments one pair at a time. This tendency to earn small, steady gains characterizes market neutral long/short equity funds in general, resulting in annual returns of about 10-12 percent, unlevered. Strong stock-picking ability can provide consistently good performance in any market and even excel in a market decline, which, in todays investment climate, is an attractive feature to investors. Long/ short equity funds posted average returns of 12.6 percent for three years 2003-2005 according to HFR.

  • Equity Long/Short Example - 1A long/short fund manager might sell short one automobile industry stock, while buying (taking a long position) on another -- short of DaimlerChrysler, long on Ford.Thereafter, any general development that improves the yield of auto industry stocks in general will help this fund's Ford position, but will hurt its DaimlerChrysler position. The two positions are offsetting, so the portfolio is hedged against developments that affect the auto industry in general.

  • Equity Long/Short Example - 2Imagine McDonalds has just come out with a low-fat burger. Burger Kings new fat-free burger, on the other hand, is dry and tasteless, producing moans in the back seat. So, sensing a trend here, you rush out and buy $5,000 worth of McDonalds stock and sell short $5,000 of Burger King. if the market goes up, both McDonalds and Burger King positions will rise in price, but McDonalds should rise more provided the analysis is correct and is ultimately recognized by other investors. Thus, the profit from the McDonalds position will more than offset the loss from the short position in Burger King. As a bonus, we will receive a rebate from broker on the short position (typically the risk-free rate of interest).

  • Equity- Long/ Short- TradesLong good stocks/short bad stocks For Eg. Infosys and Polaris

    Long value/short growth For eg. SBI and ICICI

    Long small-cap/short large-cap For eg. HLL and ITC

    Long defensive/short cyclicals Agro and SAIL

  • Representative Funds - US

    Top US Funds (Source Bloomberg, Hedge Fund Research)Fund NameHedge Fund3 Year return(2003-05)JK NavigatorSteelhead Partners71.4%Axiom International OpportunityAxiom International Investors44.5%Value PartnersValue Partners33.8%

  • Representative Funds - UK

    Top UK Funds (Source Bloomberg, Hedge Fund Research)Fund NameHedge Fund3 Year return(2003-05)SabreMathews Capital/Australia108.4%Dynamic Power HedgeGoodman & Co. Investment Counsel63.0%SR PhoeniciaSloane Robinson43.0%

  • Convertible Arbitrage

  • Define - Convertible ArbitrageConvertible arbitrage is a market neutral investment strategy often associated with hedge funds. It involves simultaneous purchase of convertible securities and the short sale of the same issuer's common stock.

  • Strategy OverviewConvertible is sometimes priced inefficiently relative to the underlying stockThe number of shares sold short usually reflects a delta neutral or market neutral ratio. As a result, under normal market conditions, the arbitrageur expects the combined position to be insensitive to fluctuations in the price of the underlying stock.However, maintaining a market neutral position may require rebalancing transactions, a process called dynamic delta hedging.When a stock declines, the associated convertible bond will decline less, because it is protected by its value as a fixed-income instrument: it pays interest periodically (while the stock may only pay a dividend, which can be suspended in bad times).At times convertible bonds declined more than the stocks into which they were convertible, apparently for liquidity reasons (the market for the stocks being much more liquid than the relatively small market for the bonds).

  • Example 1 Take a 5% convertible bond maturing in one year at $1,000, exchangeable into 100 shares of non-dividend-paying common stock currently trading at $10 per share.An arbitrage strategy might hedge against this long convertible bond with a short position of 50 shares of underlying common stock at $10 per share. Adding to gains on the downside is the fact that convertible bonds can only fall in value as low as their "investment value" -- the value of the same company bond if not convertible. In this case, let's say the investment value is $920.

  • Return When No Change in Stock Price:

    Interest payments on $1,000 convertible bond (5%) $50 Interest earned on $500 short sale proceeds (5%) $25 Fees paid to lender of common stock (0.25% per annum) ($1.50) Net cash flow $73.50 Annual Return 7.3%

  • Return When 25% Rise in Stock Price:

    Gain on convertible bond $250 Loss on shorted stock (50 shares @ $2.50/share) ($125) Interest payments on $1,000 convertible bond (5%) $50 Interest earned on $500 short sale proceeds (5%) $25 Fees paid to lender of common stock (0.25% per annum) ($1.50) Net trading gains and cash flow $198.50 Annual Return 19.85%

  • Return When 25% Fall in Stock Price:

    Loss on convertible bond (only falling as low as "investment value") ($80) Gain on shorted stock (50 shares @ $2.50/share) $125 Interest payments on $1,000 convertible bond (5%) $50 Interest earned on $500 short sale proceeds (5%) $25 Fees paid to lender of common stock (0.25% per annum) ($1.50) Net trading gains and cash flow $118.50 Annual Return 11.85%

  • Example 1 Contd.As this example shows, if a convertible bond arbitrage position is properly constructed, it should profit not only from the bond coupons and short rebate but from changes up or down in the underlying equity price.If the stock price drops, the gain from the short common stock position should exceed the corresponding loss on the long convertible bond and vice a versa.

  • Distressed Securities

  • Define - Distressed SecuritiesDistressed securities are securities of companies that are either already in default, under bankruptcy protection, or in distress and heading toward such a condition.Distressed Securities have also been defined as securities, if not in default, that have a Yield to Maturity in excess of 1000 basis points over the riskless rate of return.

  • Strategy OverviewSecurities often trade at discounts to a rational assessment of their risk-adjusted value for a variety of reasons. Distressed securities are stocks, bonds, and trade or financial claims of companies in, or about to enter or exit, bankruptcy or financial distress.The prices of these securities fall in anticipation of the financial distress when their holders choose to sell rather than remain invested in a financially troubled company.Investment professionals who specialize in researching distressed securities and who understand the true risks and values involved can scoop up these securities or claims at discounted prices