Hedge Fund Investment Strategies

Hedge Fund Investment Strategies L3: Hedge Fund Strategies

Hedge Fund Investment Strategies • Hedge funds employ dynamic investment strategies designed to find unique opportunities in the market and then actively trade their portfolio investments (both long and short) in an effort to maintain high and diversified absolute returns (often using leverage to enhance returns) • By contrast, most mutual funds only take long positions in securities and are less active in trading their portfolio investments (usually without leverage) as they attempt to create returns that track (and ideally outperform) the market • There are four broad groups of hedge fund strategies: arbitrage, event-driven, equity-related and macro • The first two groups in many cases attempt to achieve returns that are uncorrelated with general market movements, where managers try to find price discrepancies between related securities, using derivatives and active trading based on computer driven models and extensive research • The second two groups are impacted by movements in the market, and they require intelligent anticipation of price changes in stocks, bonds, foreign exchange and physical commodities L3: Hedge Fund Strategies

Four Categories L3: Hedge Fund Strategies

Strategies are Diversified L3: Hedge Fund Strategies

Equity-Based Strategies • Equity Long/Short • Also known as equity hedge strategy • It is different from equity market-neutral strategy, where managers utually hold a number of long equity position and an equal, or close to equal, dollar amount of offsetting short equity position, so that the net exposure is close to zero (dollar neutrality). • Non-Hedged Equity • No hedge involved, and investment is only long (not short) L3: Hedge Fund Strategies

Equity Long/Short • A hedge fund manager that focuses on equity long/short investing starts with a fundamental analysis of individual companies, combined with research on risks and opportunities particular to a company’s industry, country of incorporation, competitors and the overall macroeconomic environment in which the company operates • This strategy attempts to shift the principal risk from market risk to manager risk, which requires skilled stock selection to generate alpha through a concurrent purchase and sale of similar securities in an attempt to exploit relative mispricings, while decreasing market risk • Managers consider ways to reduce volatility by either diversifying or hedging positions across industries and regions and hedging undiversifiable market risk • However, the overall risk in this strategy is determined by whether a manager is attempting to prioritize returns (by having more concentration and leverage) or low risk (by creating lower volatility through diversification, lower leverage and hedging) L3: Hedge Fund Strategies

Buy on margin (page 133-138, Jaeger) • Broker typically lend 50% of the value of stock to be purchased • Vary across securities • Brokers will not lend funds against risky stocks • Margin requirement (margin=equity/assets) could be 5% or less for government securities. In the security business, the down payment is called the haircut. • Suppose you have $100,000 in a brokerage account, and you want to buy $200,000 worth of IBM stock. So you borrow $100,000 from the broker, pledging the 2000 shares of stock as collateral. The broker charges an interest of 5% annually. • What if IBM price goes up by 5% or down by 20% in a year? L3: Hedge Fund Strategies

Short sell • Page 139-146, Jaeger’s book • You open an account with $100,000 and you sell short 1000 shares of Amazon.com at $100 each. • What if the price goes down to $50/share or goes up to $120/share? • Borrowing a stock is costly • Also note that short selling creates a new interest-bearing assets • Under what condition, short selling is most profitable? • Boxing a short position (page 145-146) L3: Hedge Fund Strategies

Diversification and hedging • Both are ways to reduce risk • Diversification, see chapter 7, Jaeger • Hedging, see chapter 9, from page 146 • Shorting against the box • Basis risk L3: Hedge Fund Strategies

Equity Long/Short L3: Hedge Fund Strategies

More on Long-short • Benefits: (1) performance, (2) Interest rebate, (3) liquidity buffer interest • Costs: (1) share borrowing costs, (2) margin costs on short position, (3) transaction costs • Thoughts from Jacobs & Levy (97, The Long and Short on Long-Short) • Market-neutral long-short + long index future • Market-neutral long-short HF is not an asset class L3: Hedge Fund Strategies

Macro Strategies • Global macro • Make leverage bets on anticipated price movements in stock and bond markets, interest rates, foreign exchange, and physical commodities. • Also known as global asset allocators • Emerging market • Securities of companies and sovereign bonds L3: Hedge Fund Strategies

Global Macro • A macro focused hedge fund makes leveraged bets on anticipated price movements in stock and bond markets, interest rates, foreign exchange and physical commodities • This strategy also takes positions in financial derivatives such as forwards, options and swaps on assets such as stocks, bonds, commodities, loans, and real estate and on indexes that are focused on interest rates, stock and bond markets, exchange rates, and instruments that relate to inflation • A macro-focused fund considers economic forecasts, analysis about global flow of funds, interest rate trends, political changes, relations between governments, individual country political and economic policies and other broad systemic considerations • A well-known practitioner of a global macro investment is George Soros, who sold short more than $10 billion of pound sterling in 1992, successfully profiting from the Bank of England’s reluctance to either raise its interest rates to levels comparable to rates in other European countries or to float its currency L3: Hedge Fund Strategies

Two types of global Asset allocators • Discretionary managers • Rely on some blend of fundamental analysis and technical analysis to form a reasonable investment judgment • Growth variables • Information variables • Interest rates • Trade flow and capital flows • Equity valuation variables: P/E, price to cash flow, business value, etc • Systemic managers • Follow definite rules for putting on and taking off positions • Page 237 (JAEGER) L3: Hedge Fund Strategies

Emerging Markets • An emerging market focused hedge fund invests most of its funds in either the securities of companies in developing (emerging) countries or the sovereign debt of these countries • Emerging markets is a term used to describe a country’s social or business activity that is characterized by rapid growth and industrialization • Typically investors demand greater returns because of incremental risks L3: Hedge Fund Strategies

Arbitrage Strategies • Fixed income-based arbitrage • Convertible arbitrage • Relative value arbitrage L3: Hedge Fund Strategies

Fixed Income Arbitrage • Fixed income arbitrage funds attempt to exploit pricing inefficiencies in fixed income markets by combining long/short positions of various fixed income securities • For example, historically, because of the limited liquidity of the Italian bond futures market, the currency-hedged returns from this market in the short term were lower than the short-term returns in the very liquid U.S. Treasury bond market • However, over a longer period of time, the hedged returns became nearly identical • Fixed income arbitrageurs benefitted from the eventual convergence of hedged yields between currency-hedged Italian bond futures and U.S. Treasury bonds by shorting relatively expensive U.S. Treasury bonds and purchasing relatively cheap Italian bond futures L3: Hedge Fund Strategies

Fixed Income Arbitrage • Another example involves 30-year on-the-run and off-the-run U.S. Treasury bonds • Liquidity discrepancies between the most recently issued 30-year Treasury bonds (called on-the-run bonds) and 29.75 year Treasury bonds that were originally issued one quarter earlier (called off-the-run bonds) sometimes causes a slight difference in pricing between the two bonds • This can be exploited by buying cheaper off-the-run bonds and shorting the more expensive on-the-run bonds • Since the price of the two bonds should converge within three months (both bonds becoming off-the-run bonds), this trading position should create a profit for the arbitrageur L3: Hedge Fund Strategies

Convertible Arbitrage • A convertible bond can be thought of as a fixed-income security that has an embedded equity call option • The convertible investor has the right, but not the obligation to convert (exchange) the bond into a predetermined number of common shares • The investor will presumably convert sometime at or before the maturity of the bond if the value of the common shares exceeds the cash redemption value of the bond • The convertible therefore has both debt and equity characteristics and, as a result, provides an asymmetrical risk and return profile • Until the investor converts the bond into common shares of the issuer, the issuer is obligated to pay a fixed coupon to the investor and repay the bond at maturity if conversion never occurs • A convertible’s price is sensitive to, among other things, changes in market interest rates, credit risk of the issuer, and the issuer’s common share price and share price volatility L3: Hedge Fund Strategies

Convertible Arbitrage • Convertible Arbitrage is a market neutral investment strategy that involves the simultaneous purchase of convertible securities and the short sale of common shares (selling borrowed stock) that underlie the convertible • An investor attempts to exploit inefficiencies in the pricing of the convertible in relation to the security’s embedded call option on the convertible issuer’s common stock • In addition, there are cash flows associated with the arbitrage position that combine with the security’s inefficient pricing to create favorable returns to an investor who is able to properly manage a hedge position through a dynamic hedging process • The hedge involves selling short a percentage of the shares that the convertible can convert into based on the change in the convertible’s price with respect to the change in the underlying common stock price (delta) and the change in delta with respect to the change in the underlying common stock (gamma) L3: Hedge Fund Strategies

Convertible Arbitrage • The short position must be adjusted frequently in an attempt to neutralize the impact of changing common share prices during the life of the convertible security (this process of managing the short position in the issuer’s stock is called “delta hedging”) • If hedging is done properly, whenever the convertible issuer’s common share price decreases, the gain from the short stock position should exceed the loss from the convertible holding, and whenever the issuer’s common share price increases, the gain from the convertible holding should exceed the loss from the short stock position • The investor will also receive the convertible’s coupon payment and interest income associated with the short stock sale • However, this cash flow is reduced by paying a cash amount to stock lenders equal to the dividend the lenders would have received if the stock were not loaned to the convertible investor, and further reduced by stock borrow costs and interest expense on any borrowings to finance the investment L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage A convertible arbitrageur attempts to purchase undervalued convertibles and simultaneously short a number of common shares that the convertible can convert into (the "conversion ratio"). The number of shares sold short depends on the conversion ratio and the delta. The delta measures the change in the convertible's price with respect to the change in the underlying common stock price, which represents the convertible's equity sensitivity for very small stock price changes. The arbitrageur's objective is to create an attractive rate of return regardless of the changing price of the underlying shares. This is achieved by capturing the cash flows available on different transactions that relate to the convertible as well as directly from the convertible and by profiting from buying a theoretically cheap convertible. Many convertibles are originally issued at a price below their theoretical value because the stock price volatility assumed in the convertible pricing is below the actual volatility that is expected during the life of the convertible. A summary of potential convertible returns is as follows: 1. Income Generation The arbitrageur tries to generate income while hedging the risks of various components of a convertible bond. Income from a convertible hedge comes from the following: Coupon + interest on Short Proceeds – Stock Dividend – Stock Borrow Cost. This income is increased if the arbitrageur leverages the investment (two or three times leverage is common). However, costs associated with hedging interest rate and credit risks reduce the income. An example of income generation, which is linked to Figure 2, follows: Exhibit 12.4 (1 of 7) L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage Assuming that an issuer’s common stock price is $41.54 and dividend yield is 1% when a $1,000 convertible is issued and the convertible has a 2.5% coupon, a conversion ratio of 21.2037, 53% average short stock position (with 2% interest income available from this position) and a stock borrow cost of 0.25% on the short proceeds, over a one year horizon, the total income from a delta hedged convertible would be $28.50, which is equal to 2.9% of the $1,000 convertible: L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage 2. Monetizing Volatility Because of the nonlinear relationship between prices for the convertible and for the underlying stock, there is an additional gain potential in creating a delta neutral position between the convertible and the stock. This is explained in Figure 1. At point 1, the green line represents the long convertible position, whereas the dotted line represents the delta neutral exposure. Therefore, if the stock price were to fall from position 1, the gain on the short stock position is greater than the loss from the long convertible position (position A). However, if the stock were to gain, the loss on the short would be less than the gain on the convertible (position B). L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage Figure 2: CONVERTIBLE ARBITRAGE TRADE Stock Px = $41.54 Convertible delta = 53% Conv. Ratio = 21.2037 shares Convertible Px = 101.375% par Note: calculations are not rounded. L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage Figure 3: LONG-ONLY TRADE (ONE YEAR) Stock Px = $41.54 Convertible delta = 53% Conv. Ratio = 21.2037 shares Convertible Px = 101.375% par Note: calculations are not rounded. L3: Hedge Fund Strategies

Mechanics of Convertible Arbitrage 3. Purchasing Undervalued Convertible An important source of additional potential profit comes from purchasing a convertible at a price that is below its theoretical value, from an implied volatility perspective. When this happens and the convertible exposures are properly neutralized through delta hedging, incremental profits will be created over time based on the below-market purchase. These profits will be even higher if there is an increase in volatility during the holding period. However, if volatility decreases, this potential profit opportunity can turn into a potential loss. If a convertible is purchased at a 2% discount to theoretical value, this could result in a profit of $20 (2% of the $1,000 convertible). 4. Summary of Returns The total one-year convertible return in this hypothetical, hedged convertible is comprised of • Income Generation (2.9%), • Monetizing Volatility (1.4%), • Purchasing an Undervalued Convertible (2%, calculated for a one-year holding period). This results in a hypothetical return of 6.3%. If one-half of this convertible is purchased with $500 borrowed from a Prime Broker at 2%, the total one-year return from this investment would be approximately 10.6% ($1,000 x 6.3% = $63. $63 - $10 interest cost = $53. $53/$500 = 10.6%) L3: Hedge Fund Strategies

Relative Value Arbitrage • Relative value arbitrage exploits pricing inefficiencies across asset classes • An example of this is “pairs trading”, which involves two companies that are competitors or peers in the same industry that have stocks with a strong historical correlation in daily stock price movements • When this correlation breaks down (one stock increases in price while the other stock decreases in price) a pairs trader will sell short the outperforming stock and buy the underperforming stock, betting that the “spread” between the two stocks will eventually converge • When, and if, convergence occurs, there can be significant trading profits • Of course, if divergence occurs, notwithstanding the strong historical correlations, this trade can lose money L3: Hedge Fund Strategies

Equity Market Neutral Strategies • Page 242, Jaeger book • Market neutral long-short equity • Pair trading: e.g., taking a long position in Cisco, paired with a short position in Microsoft • Single-sector fundamental investors: long-short stocks in the single sector – develop a detailed knowledge of the companies in which he is investing, from both the long and short sides • Multi-sector fundamental investors: scoring stocks based on a wide variety of factors; then buying the stocks that score high and selling short the stocks that score low. • Multi-sector technical traders: care about price movement and relative pricing. Look for situations in which prices have gotten out of line but are expected to go back in line within days. L3: Hedge Fund Strategies

Event Driven Strategies • Event driven strategies focus on significant transactional events such as M&A transactions, bankruptcy reorganizations, recapitalizations and other specific corporate events that create pricing inefficiencies L3: Hedge Fund Strategies

Activist Investors • Activist investors take minority equity or equity derivative positions in a company and then try to influence the company’s senior management and board to consider initiatives that the activist considers important in order to enhance shareholder value • This strategy is sometimes called Shareholder Activism • Activist investors often attempt to influence other major investors to support their recommendation to the company, which sometimes leads to proxy solicitations designed to change the management composition of the company • Activist investors commonly push for lower costs, lower cash balances, greater share repurchases, higher dividends and increased debt, among other things L3: Hedge Fund Strategies

Merger Arbitrage • In a stock-for-stock acquisition, some traders will buy the target company’s stock and simultaneously short the acquiring company’s stock, creating a “risk arb” position that is called Merger Arbitrage or Risk Arbitrage • The purchase is motivated by the fact that after announcement of a pending acquisition, the target company’s share price typically trades at a lower price in the market compared to the price reflected by the Exchange Ratio that will apply at the time of closing • Traders who expect that the closing will eventually occur can make trading profits by buying the target company’s stock and then receiving the acquiring company’s stock at closing, creating value in excess of their purchase cost • To hedge against a potential drop in value of the acquiring company’s stock, the trader sells short the same number of shares to be received at closing in the acquiring company’s stock based on the Exchange Ratio • Risk arb trading puts downward pressure on the acquiring company’s stock and upward pressure on the selling company’s stock L3: Hedge Fund Strategies

Merger Arbitrage • As an example, if an acquiring company agrees to purchase a target company’s stock at an Exchange Ratio of 1.5x, then at closing, the acquirer will deliver 1.5 shares for every share of the target’s stock • Assume that just prior to when the transaction is announced, the target’s stock price is $25, the acquirer’s stock is $20, and it will be six months until the transaction closes • Since 1.5 acquirer shares will be delivered, the value to be received by target company shareholders is $30 per share • However, because there is some probability the acquisition doesn’t close in 6 months, the target company stock will likely trade below $30 until the date of closing L3: Hedge Fund Strategies

Merger Arbitrage • If the target stock trades at, for example, $28 after announcement, for every share of target stock that risk arbs purchase at $28, they will simultaneously short 1.5 shares of the acquirer’s stock • This trade enables risk arbs to profit from the probable increase in the target’s share price up to $30, assuming the closing takes place, while hedging its position (the shares received by risk arbs at closing will be delivered to the parties that originally lent shares to them) • The objective for risk arbs is to capture the spread between the target company’s share price after announcement of the deal and the offer price for the target company, as established by the Exchange Ratio, without exposure to a potential drop in the acquirer’s share price • However, if the transaction doesn’t close or the terms change, the risk arbs’ position becomes problematic and presents either a diminution in profit or a potential loss L3: Hedge Fund Strategies

Merger Arbitrage L3: Hedge Fund Strategies

Distressed Securities • Distressed securities investment strategies are directed at companies in distressed situations such as bankruptcies and restructurings or companies that are expected to experience distress in the future • 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 financial distress when their holders choose to sell rather than remain invested in a financially troubled company (and there is a lack of buyers) • If a company that is already distressed appears ready to emerge from this condition, the prices of the company’s securities may increase • Due to the market’s inability to always properly value these securities, and the inability of many institutional investors to own distressed securities, these securities can sometimes be purchased at significant discounts to their risk adjusted value L3: Hedge Fund Strategies

Distressed Securities L3: Hedge Fund Strategies

More on distressed securities • Page 277- 281, Jaeger book • Professional investors in distressed companies assume that the equity is worthless, so their task is to decide which class of debt offers the most attractive risk-reward tradeoff. • Value of the strategy • Investment skill (to tell which security has value) • Offer liquidity to traditional investors who prefer investment grades • Distressed debt investors try to invest in good companies that have a bad capital structure • Distressed debt market is relatively small and it is linked to the broader economy. L3: Hedge Fund Strategies

Hedge Fund Investment Strategies