Relative value

investment strategies
Relative value strategies are focused on identifying discrepancies in prices
among securities that share similar economic or financial characteristics (e.g.,
2-year and 10-year U.S. Treasury securities). The strategy is based on the
premise that one or more of the related securities are mispriced, given that they
have valuation factors in common – such as interest rate, index or sovereign or
corporate issuer. Managers may employ a variety of quantitative and qualitative
Leola Ross, Ph.D., CFA,
techniques to identify securities they believe to be mispriced relative to Director, Investment Strategy
Research
fundamental and technical factors.

By taking concurrent long and short  Yield alternatives encompass other

positions in the related securities, the
manager aims to capture performance and
mitigate risk, while minimizing the
portfolio’s correlation to overall market
beta. Three broad sub-strategies fall under
the “relative value” category: fixed income,
volatility and yield alternatives.
Relative value sub-strategies
 Fixed income securities used in the
relative value strategy may include
sovereign bonds, interest rate swaps,
futures, mortgage- and asset-backed
securities, municipal bonds and
corporate debt. The pairs or groups of
securities traded will share a common
interest rate or credit spread component,
such as bonds vs. bonds, futures and/or
swaps; mortgage pass-throughs vs.
specific mortgage pools; senior vs.
subordinated debt; and bond vs. credit
default swap (CDS) basis trades.
 Volatility focuses on assets where
implied (i.e., expected) volatility is a
significant component of the price of the
security, such as convertible bonds
(convertible arbitrage) and equity options
(term structure, dispersion and skew
trades).
niche markets wherein relative price and
yield dislocations occur, but are not
predominantly volatility- or interest rate–
dependent. Assets in the yield
alternatives sub-strategy may include
insurance-linked securities, energy
master limited partnerships (MLPs),
infrastructure assets and real estate
assets. This sub-strategy tends to be
more idiosyncratic in nature than other
relative value strategies, with a longer
expected investment period.
Relative value strategies provide
diversification, both to other hedge fund
strategies and to traditional asset classes.
Relative value is characterized by
comparatively low volatilities and market
neutrality.
Some of the more challenging aspects of
relative value are its complexity, illiquidity,
non-transparency and use of esoteric
securities. All of these characteristics
inhibit the ability of standard analytics
packages to evaluate portfolios.
Ultimately, specialized tools and expertise
are critical to understanding, evaluating
and selecting relative value portfolios.

Russell Investments // Relative value investment strategies JUNE 2014

Frank Russell Company owns the Russell trademarks used in this material. See “Important information” for details.
The chart below illustrates the potential sources of return and the possible risks investors
should consider when deciding whether to utilize a relative value strategy.

Return sources and risks

STRATEGIES POTENTIAL RETURN SOURCES RISKS TO CONSIDER
Fixed income  Price/spread convergence  Basis risk, i.e. hedging instrument and investment
 Curve normalization instrument de-coupling; spread widening; forced
 Security selection deleveraging; security-specific problems; sudden reversals
of liquidity; default risk, interest rate and idiosyncratic credit
 Leverage
events
 Structural mispricing
 Credit
Volatility  Return is possible from most of the “greeks” For volatility arbitrage (“arb”):
arbitrage (theta, vega, delta, gamma)  Idiosyncratic risk associated with underlying issues;
 Implied vs. realized volatility in equity options complexity; high leverage
 Equity price volatility For convertible arb:
 Credit from convertible bonds  The volatility arb risks, plus credit risk (many issues are not
 Leverage rated by any of the agencies); liquidity risk; co-investor risk,
due to the concentration of positions held by hedge fund
 Term structure
managers; short squeezes
Yield alternatives  Long-duration yields  Illiquidity, appraisal models, some equity market risks,
 Credit credit, interest rates and macroeconomic conditions
 Interest carry
 Security selection
 Information asymmetries
 Demographics

ADDITIONAL CONTRIBUTING AUTHOR

Heather Myers

FOR MORE INFORMATION:

Call Russell Investments at 800-426-8506 or visit russellinvestments.com/institutional
Important information

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any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific
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Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even
rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at
certain times, unintentionally reduce returns.
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than other investments. Hedge strategies and private equity investments are not subject to the same regulatory requirements as registered investment
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First used: June 2014 (Reviewed for continued use: November 2017) AI-26094-11-20

Russell Investments // Relative value investment strategies 2