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In this type of Hedge Fund Strategy, Investment manager maintains long and short
Thus, the fund manager will purchase the stocks that they feels is undervalued and
specific sectors.
market capitalization and valuations.
Basically, the fund goes long and short in two competing companies in the same
industry.
But most managers do not hedge their entire long market value with short positions.
Tata Motors and short an equal value of Hyundai shares. The net market exposure is
But if Tata Motors does outperform Hyundai, the investor will make money no matter
for $127,000, covers the Hyundai short for $120,000 and pockets $7,000.
If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for $77,000,
covers the Hyundai short for $70,000, and still pockets $7,000.
If the trader is wrong and Hyundai outperforms Tata Motors, however, he will lose
money.
which means that shorts and longs have equal market value.
In such a case the managers generate their entire return from stock selection.
This strategy has a lower risk than the first strategy that we discussed, but at the
Therefore, in such a case the gains and losses will offset each other inspite how the
So even if the sector moves in any direction the gain on the long stock is offset by a
This particular hedge fund strategy looks at the risk that the merger deal will not
The target company’s stock will sell at a discount to the price that the combined
The merger arbitrageurs care only about the probability of the deal being approved
Suppose ABC Co is trading at $20 per share when XYZ Co. comes along and bids
The stock of ABC will jump up, but will soon settle at some price which is higher than
$20 and less than $30 until the takeover deal is closed.
Let’s say that the deal is expected to close at $30 and ABC stock is trading at $27.
To seize this price-gap opportunity, a risk arbitrageur would purchase ABC at $28,
pay a commission, hold on to the shares, and eventually sell them for the agreed
fees.
# 4 CONVERTIBLE ARBITRAGE
A convertible arbitrage hedge fund typically includes long convertible bonds and
In simple terms it includes a long position on bonds and short position on common
stock or shares.
It attempts to exploit profits when there is a pricing error made in the conversion
factor i.e. it aims to capitalize on mispricing between a convertible bond and its
underlying stock.
the arbitrageur will take a long position in the convertible bond and a short position in
the stock.
On the other hand, if the convertible bond is overpriced relative to the underlying
stock, the arbitrageur will take a short position in the convertible bond and a long
In such a strategy managers try to maintain a delta-neutral position so that the bond
remains unchanged when small changes occur in the value of the underlying
security.)
The reason for the same is that, more the shares bounce, more the opportunities
first day of trading it has a par value of $1,000 and if you held it to maturity (1 year)
bondholder desires to get them converted. The stock price at that time was $20.
If Vision’s stock price rises to $25 then the convertible bondholder could exercise
their conversion privilege. They can now receive 50 shares of Vision’s stock.
50 shares at $25 is worth $1250. So if the convertible bondholder bought the bond at
issue ($1000), they have now made the profit of $250. If instead they decide that
they want to sell the bond, they could command $1250 for the bond.
But what if the stock price drops to $15? The conversion comes to $750 ($15 *50). If
this happens you could simply never exercise your right to convert to common
shares. You can then collect the coupon payments and your original principal at
maturity.
security is sold.
Its objective is to profit from the pricing inefficiency in the issuing firm’s capital
structure.
hedge funds.
It includes going long in one security in a company’s capital structure while at the
same time going short in another security in that same company’s capital structure.
For example, long the sub-ordinate bonds and short the senior bonds, or long equity
In such a case, both its bond and stock prices are likely to fall heavily. But the stock
Stockholders are at a greater risk of losing out if the company is liquidated because
The market for stocks is usually more liquid as it reacts to news more dramatically.
# 6 FIXED-INCOME ARBITRAGE
This particular Hedge fund strategy makes profit from arbitrage opportunities in
Here opposing positions are assumed in the market to take advantage of small price
inconsistencies, limiting interest rate risk. The most common type of fixed-income
In swap-spread arbitrage opposing long and short positions are taken in a swap and
a Treasury bond.
Point to note is that such strategies provide relatively small returns and can cause
front of a steamroller!’
$200.
The Hedge Fund Manager Shorts Interest Rate Swaps for two companies that pays out 6%
Now if this is what the Manager pays out, then we must subtract this from the interest made
# 7 EVENT DRIVEN
In such a strategy the investment Managers maintain positions in companies that are
In this type of strategy, the hedge funds buy the debt of companies that are in financial
If the company has yet not filed for bankruptcy, the manager may sell short equity, betting
# 8 GLOBAL MACRO
This hedge fund strategy aims to make profit from large economic and political
and currencies.
Investment managers analyze the economic variables and what impact they will
The Managers analyze how macroeconomic trends will affect interest rates,
currencies, commodities or equities around the world and take positions in the asset
approaches, long and short-term holding periods are applied in such case.
Managers usually prefer highly liquid instruments like futures and currency forwards
sterling in 1992. He then took a huge short position of over $10 billion worth of pounds.
He consequently made a profit from the Bank of England’s reluctance to either raise its
interest rates to levels comparable to those of other European Exchange Rate Mechanism
# 9 SHORT ONLY
Short selling is an investment strategy which includes selling the shares that are
In order to successfully implement this strategy, the fund managers have to scour
the financial statements, talk to the suppliers or competitors to dig any signs of
Below are the Top Hedge Funds of 2014 with their respective hedge fund strategies-
source: Prequin
Also, note the the hedge funds Strategy distribution of the Top 20 hedge funds compiled by
Prequin
source: Prequin
Clearly, Top hedge funds follow Equity Strategy with 75% of the Top 20 funds
Macro Strategy, Event Driven and Multi-Strategy makes the remaining 15% of the
strategy
Are Hedge Funds different from Investment Banks? – Check this investment banking
vs hedge fund
CONCLUSION
Hedge Funds do generate some amazing compounded annual returns. However, these
returns depend on your ability to properly apply Hedge Funds Strategies to get those
handsome returns for your investors. While majority of the hedge funds apply Equity
Strategy, others follow Relative Value, Macro Strategy, Event Driven etc. You can also
master these hedge fund strategies by tracking the markets, investing and learning
continuously.