Hedge Fund Strategies

Table of Contents
1. READING 34 - HEDGE FUND STRATEGIES - EXAM FOCUS
2. MODULE 34.1: OVERVIEW OF HEDGE FUND STRATEGIES
3. MODULE 34.2: EQUITY, EVENT-DRIVEN, AND RELATIVE VALUE STRATEGIES
4. MODULE 34.3: OPPORTUNISTIC, SPECIALIST, AND MULTI-MANAGER STRATEGIES
5. MODULE 34.4: FACTOR MODELS AND PORTFOLIO IMPACT OF HEDGE FUNDS
6. KEY CONCEPTS
7. ANSWER KEY FOR MODULE QUIZZES
8. TOPIC QUIZ: ALTERNATIVE INVESTMENTS
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READING 34 - HEDGE FUND STRATEGIES - EXAM FOCUS

This reading describes major hedge fund strategy categories, examines their investment characteristics, explains how these strategies are implemented, and shows how to interpret a model for understanding the risk exposures of each strategy. After studying this chapter you should:

• Understand the investment characteristics and implementation approaches for six major hedge fund strategy categories.
• Be able to interpret a conditional linear factor model for hedge fund risk exposures.
• Be able to evaluate the likely portfolio impact of allocating to different hedge fund strategies.

MODULE 34.1: OVERVIEW OF HEDGE FUND STRATEGIES

Introduction

Hedge funds form an important subgroup of alternative investments. They are distinct from traditional pooled investment vehicles (such as mutual funds) in a number of ways. Key distinguishing features include:

• Lower regulatory and legal constraints compared with many registered investment vehicles.
• Flexibility to use short selling and derivatives, enabling both long and short exposures plus use of options, futures, swaps, and other derivative instruments.
• A larger investment universe that can include equities, fixed income, commodities, currencies, volatility products, insurance-linked securities, and complex structured products.
• Aggressive investment exposures - many hedge funds target absolute returns and may use active trading and tactical allocations.
• Comparatively free use of leverage to amplify position size and potential returns (and losses).
• Liquidity constraints for investors - lock-ups, gates, and periodic redemptions are common.
• Lack of transparency relative to publicly regulated funds.
• Higher cost structures typically including management and performance fees.

The key practical question for investors is whether the higher expense and complexity of hedge funds are justified by the return and diversification benefits they may provide. Some investors allocate to hedge funds seeking persistent sources of alpha (manager skill), while others invest to obtain access to specialised investment talent or exposures that are difficult to replicate in a conventional portfolio.

Classifications of Hedge Fund Strategies

Hedge fund strategies may be classified by the types of securities used, the trading approach, and the principal sources of risk and return. For clarity in this chapter, we group hedge fund strategies into the following six categories:

• Equity-related - strategies that focus primarily on stocks (examples: long/short equity, dedicated short bias, equity market neutral).
• Event-driven - strategies that seek to profit from corporate events such as mergers & acquisitions, bankruptcies, restructurings (examples: merger arbitrage, distressed securities).
• Relative value - strategies that exploit valuation differences between related securities, often using fixed-income and hybrid securities (examples: fixed-income arbitrage, convertible bond arbitrage).
• Opportunistic - top-down strategies that span multiple asset classes and regions depending on market conditions (examples: global macro, managed futures).
• Specialist - niche strategies requiring specialised expertise (examples: volatility strategies, reinsurance and life settlements).
• Multi-manager - strategies that combine other hedge fund strategies or managers, such as multi-strategy funds and funds-of-funds (FoF).

MODULE QUIZ 34.1

1. A convertible bond arbitrage strategy is most likely to be classified as a(n):
   • A. specialist strategy.
   • B. event-driven strategy.
   • C. relative value strategy.
2. A managed futures hedge fund strategy is most likely to be classified as a(n):
   • A. opportunistic strategy.
   • B. specialist strategy.
   • C. relative value strategy.

MODULE 34.2: EQUITY, EVENT-DRIVEN, AND RELATIVE VALUE STRATEGIES

LOS 34.b - Equity-Related Hedge Fund Strategies

Equity-related hedge fund strategies focus primarily on the stock market. The principal source of risk and return is equity exposure. Common subtypes are long/short equity, dedicated short or short-biased, and equity market neutral funds.

Long/Short Equity

In a long/short (L/S) equity fund, the manager takes long positions in stocks expected to appreciate and short positions in stocks expected to decline.

Investment Characteristics

When combining longs and shorts, the portfolio's market exposure (beta) is the weighted sum of the betas of individual positions, including negative contributions from short positions. L/S funds typically do not seek zero market exposure; instead, many maintain a modest net long exposure (commonly around 40% to 60%) to capture the general upward drift of equity markets over time. L/S managers often aim to achieve returns comparable to long-only equity with lower standard deviation - often conceptualised as similar return but roughly half the volatility.

Strategy Implementation

Successful L/S implementation depends on security selection. Many managers adopt a sector or industry focus to exploit specialised knowledge. Market-neutral L/S strategies, which reduce net beta, commonly employ leverage to achieve attractive returns because beta-driven returns are absent or reduced. Index funds or ETFs may also be used tactically to obtain desired exposures.

Role in a Portfolio

L/S equity funds seek to generate stock-specific alpha while retaining a moderate long market exposure. Analysts evaluating L/S investments must weigh whether the fund's fees are justified versus taking a simpler long-only position, especially when the desired market beta could be obtained more cheaply through traditional funds.

Dedicated Short Selling and Short-Biased Strategies

Dedicated short-selling funds hold predominantly short positions in securities they believe are overvalued. Short-biased funds also hold significant short positions but maintain some long exposure so the fund is net short rather than purely short.

Investment Characteristics

Short strategies are designed to produce negative correlation with traditional long-only portfolios. Expected returns from short strategies are generally lower than from long-based strategies, and short strategies can show greater volatility because equity markets historically trend upwards.

Strategy Implementation

Short selling is implemented by borrowing securities and selling them, hoping to repurchase at a lower price later to return to the lender. Effective shorting requires detailed, bottom-up analysis: identifying firms with poor business models, weak management, high leverage, shrinking markets, or fraudulent accounting. Dedicated short sellers often maintain gross short positions in the range of 60% to 120% and may hold cash to offset market exposure. Short-biased managers are typically net short by around 30% to 60% and generally use little leverage.

Role in a Portfolio

Dedicated short and short-biased funds aim to deliver returns that are uncorrelated or negatively correlated with conventional assets, offering potential diversification benefits. These benefits come at the cost of lower expected returns and potentially higher volatility for pure short exposures.

Equity Market Neutral (EMN)

Equity market-neutral funds target near-zero overall market exposure (beta ≈ 0) by pairing long and short equity positions so weighted betas sum to zero. Alpha is generated by exploiting temporary mispricings between securities.

Investment Characteristics

EMN strategies aim to generate alpha while being relatively insensitive to broad market moves. Without market beta, returns are typically modest, but volatility and correlation with equities are low, making EMN funds valuable diversifiers.

Strategy Implementation

EMN managers go long stocks deemed undervalued and short those judged overvalued, expecting mean reversion. EMN implementation is often quantitative, using systematic rules to identify opportunities; some managers use discretionary approaches. Because market beta is intentionally hedged away, leverage is commonly applied to achieve acceptable returns. Popular EMN subtypes include:

• Pairs trading - trade two similar stocks that diverge from historical co-integration and profit when the spread reverts.
• Stub trading - trade shares of a parent and subsidiary according to ownership stakes to exploit mispricings.
• Multi-class trading - exploit valuation differences across share classes (e.g., voting vs non-voting shares).

Derivatives such as options, stock index futures, and other instruments can also be used to achieve a target beta of zero.

Role in a Portfolio

EMN funds can offer alpha with low market correlation and lower volatility than beta-oriented funds. They tend to perform relatively well in volatile or falling markets when market beta is a drag on returns.

LOS 34.c - Event-Driven Strategies

Event-driven strategies seek to profit from corporate actions or organisational events (e.g., mergers, acquisitions, restructurings, bankruptcies). Managers take positions in affected securities or related derivatives. Two approaches are:

• Soft-catalyst - investments made before an event is announced; generally more volatile and riskier.
• Hard-catalyst - investments made after a corporate event announcement; aims to exploit incomplete price adjustment.

The principal risk is event risk - the possibility that the actual outcome differs from expectations (e.g., a merger fails, a restructuring yields less recovery than anticipated).

Merger Arbitrage

Merger arbitrage attempts to capture the spread between the market price of the target and the deal consideration between announcement and deal completion. It is often described as selling insurance on the deal: if the deal completes, the investor earns the spread; if it fails, a potentially large loss can occur.

Investment Characteristics

If a deal fails, prices typically revert: target share price falls and acquirer share price rises, creating large downside for a fund positioned for success (losses can be large - on the order of tens of percent). Merger arbitrage tends to be relatively liquid compared with many hedge fund strategies but has significant left-tail risk.

Strategy Implementation

In a typical stock-for-stock transaction, a merger arbitrageur buys the target's stock and shorts the acquirer's stock, aiming to profit when the exchange ratio is realised on deal completion. If a manager believes a deal will fail, opposite positions are taken. Because spreads are often modest, managers commonly use high leverage (examples in practice: 300% to 500% leverage) to achieve low-double-digit returns. Cross-border deals add regulatory and execution risk due to multiple jurisdictions and regulatory authorities.

Role in a Portfolio

Merger arbitrage often delivers steady returns with high Sharpe ratios when deals close as expected, but the left-tail event risk from deal failure is a material concern for risk management.

Distressed Securities

Distressed securities strategies invest in securities of firms in financial distress or bankruptcy. Reasons for distress include excessive leverage, competitive disadvantages, sector declines, or accounting fraud. Distressed assets often trade at deep discounts due to forced selling - for example, regulatory or mandate-driven selling by institutions unable to hold non-investment-grade assets.

Investment Characteristics

Relative to other event-driven strategies, distressed securities can offer higher expected returns but with greater variability and illiquidity. Lock-up periods for investors are often long because valuing and exiting distressed positions can take extended time (for example, recovery through bankruptcy or reorganisation). In liquidation, proceeds are distributed in priority order: senior secured debt, junior secured debt, unsecured debt, convertible debt, preferred stock, and finally common equity.

Strategy Implementation

Distressed investing ranges from passive holdings to active creditor roles where the investor accumulates a sizeable claim to influence restructurings. Success requires legal and restructuring expertise to navigate bankruptcy proceedings and renegotiations. Most distressed investments are long positions, with relatively low use of leverage.

Role in a Portfolio

Distressed strategies contribute higher, but less predictable, returns and often introduce illiquidity. They can enhance overall portfolio returns but are sensitive to broader credit market conditions.

LOS 34.d - Relative Value Strategies

Relative value strategies exploit pricing differences between related securities. Typical instruments include fixed-income securities, hybrid securities, and convertibles. Relative value returns reflect capture of liquidity, credit, and volatility premiums; however, extreme market stress can produce losses.

Fixed-Income Arbitrage

Fixed-income arbitrage involves taking long positions in undervalued bonds and short positions in overvalued bonds, or trading based on anticipated changes in the yield curve shape. Instruments include corporate bonds, bank loans, sovereign debt, and mortgage-backed securities.

Strategy Implementation

Two common subtypes are:

• Yield curve trades - form a forecast for how the yield curve will change (steepen or flatten) and take offsetting positions to profit from the anticipated move. Risks include interest-rate risk and, if different issuers are used, credit and liquidity risk.
• Carry trades - short a low-yield security and go long a higher-yield security, profiting from the yield differential plus expected price convergence.

Investment Characteristics

Because fixed-income markets are generally efficient, profit opportunities are limited; consequently, fixed-income arbitrageurs typically employ substantial leverage (examples historically reported: 400% leverage or sometimes higher). Liquidity varies by instrument - Treasuries are very liquid, mortgage-backed and foreign instruments less so.

Role in a Portfolio

Returns of fixed-income arbitrage can resemble the payoff of writing puts: steady small gains when spreads tighten, but potentially large losses if spreads widen while positions are highly leveraged. High leverage can cause margin-call driven deleveraging and forced asset sales, leading to cascade effects (for example, events surrounding the collapse of Long-Term Capital Management in 1998 illustrate these risks).

Convertible Bond Arbitrage

Convertible bonds are debt securities with embedded options allowing bondholders to convert into a specified number of shares. They can be viewed as holding a straight bond plus a long call option on the issuing company's stock. Convertible arbitrage strategies aim to capture underpriced implied volatility in convertibles while hedging delta and other risks by taking offsetting positions (commonly short equity).

Investment Characteristics

Convertible arbitrage faces liquidity challenges from (1) required shorting of the underlying equity, and (2) convertible instruments that may be niche or complex.

Strategy Implementation

Implementation involves assessing the convertible's behaviour across states:

• When the conversion price is well above the current stock price (deep out-of-the-money), the convertible behaves like a straight bond (delta ≈ 0).
• When the conversion price is well below the current stock price (deep in-the-money), the convertible behaves like stock (delta ≈ 1).

Arbitrageurs hedge delta and gamma risks using short equity positions sized according to the option delta and typically employ leverage (for example, ~3× long bond exposure and ~2× short equity exposure in some implementations).

Role in a Portfolio

Convertible arbitrage performs best in environments of sufficient liquidity, moderate volatility, and active issuance of convertible bonds. It can suffer during episodes of illiquidity or severe credit stress.

MODULE QUIZ 34.2

1. Considering the following equity hedge fund strategies, the strategy that is most likely to apply relatively high levels of leverage is a(n):
   • A. equity market neutral strategy.
   • B. dedicated short strategy.
   • C. short-biased strategy.
2. An equity-related hedge fund strategy with gross exposures of 80% long and 35% short is most likely to be classified as a:
   • A. dedicated short strategy.
   • B. short-biased strategy.
   • C. long/short equity strategy.
3. Relative to other hedge fund strategies, equity market neutral strategies are most likely to:
   • A. exhibit relatively modest returns.
   • B. be vulnerable to periods of market weakness.
   • C. earn return from alpha and beta risk.
4. An investment in distressed securities is most likely to be characterized by a:
   • A. long bias.
   • B. high level of liquidity.
   • C. large amount of leverage.
5. In a sequential payoff during a liquidation, the security holder that is most likely to be paid off first is the holder of:
   • A. junior secured debt.
   • B. convertible debt.
   • C. preferred stock.
6. In implementing a convertible arbitrage strategy, a portfolio manager is most likely to take a position that is:
   • A. long convertible bonds and short equity.
   • B. long straight bonds and short convertible bonds.
   • C. long convertible bonds and short straight bonds.

MODULE 34.3: OPPORTUNISTIC, SPECIALIST, AND MULTI-MANAGER STRATEGIES

LOS 34.e - Opportunistic Strategies

Opportunistic strategies are top-down, span multiple asset classes and geographies, and adapt to market conditions. They can be implemented using technical analysis, fundamental macro analysis, systematic algorithms, or discretionary judgement. Risks and returns depend on chosen asset classes and techniques. Two principal opportunistic strategies are global macro and managed futures.

Global Macro

Global macro managers forecast macroeconomic variables - inflation, exchange rates, yield curve movements, and central bank policies - and take positions across global asset classes (equities, bonds, currencies, commodities, derivatives) to express those views.

Investment Characteristics

Global macro funds may take directional or thematic positions. They generally perform poorly in low-volatility mean-reverting markets and perform well when able to identify and enter trends early. Returns tend to be lumpy and volatile because they depend on successful macro forecasts and the timing of trades.

Strategy Implementation

Global macro approaches are top-down: analyse global macroeconomic conditions, identify themes, then choose instruments to express views. Implementation styles vary - discretionary versus systematic, fundamental versus technical. Global macro funds commonly apply substantial leverage (examples in practice: 600%-700% gross exposures relative to fund assets), reflecting large directional bets or the use of derivatives.

Role in a Portfolio

Global macro allocations can add both alpha and diversification to a traditional portfolio. They may provide contrarian returns in stressed markets and have historically produced right-tail skewed payoffs in some crises, though such outcomes are not guaranteed.

Managed Futures

Managed futures funds take positions in derivatives (futures, forwards, options on futures, swaps) across asset classes including commodities, interest rates, equities, and currencies. Strategies range from simple index futures trades to sophisticated cross-asset systematic approaches.

Investment Characteristics

Managed futures do not usually hold physical assets but obtain exposures via derivatives collateralised with a small amount of margin. Because of this, they can apply high leverage in practice (for example, posting a small fraction of notional as margin). Futures are highly liquid and trade continuously on regulated exchanges, allowing fast entry and exit. A common risk is crowding where many managers follow similar signals, increasing execution slippage and reducing prospective returns.

Strategy Implementation

Popular implementation methods include:

• Time-series momentum (TSM) - buy assets with positive past returns and short assets with negative past returns.
• Cross-sectional momentum (CSM) - within an asset class, buy fastest-rising instruments and short fastest-falling instruments.

Trade entry and exit are typically governed by signal triggers (e.g., momentum thresholds, volatility filters) and exit rules (price targets, momentum reversal, time limits, trailing stops). Position sizing commonly accounts for individual asset volatility and correlations.

Role in a Portfolio

Managed futures historically show low correlation with traditional equities and bonds, and often have right-skewed returns during crises, making them strong diversifiers for conventional portfolios.

LOS 34.f - Specialist Strategies

Specialist strategies operate in niche markets and require specialised knowledge. They aim to generate uncorrelated returns using expertise unavailable to generalist managers. Two examples are volatility trading and reinsurance / life settlements.

Volatility Trading

Volatility trading involves trading instruments whose payoffs depend on realised or implied volatility. Managers buy underpriced volatility and sell overpriced volatility across regions and asset classes.

Examples of volatility relationships include the observation that implied volatility levels may differ across exchanges or regions (e.g., implied volatility may be lower in one market relative to another despite higher realised volatility). Another volatility trade is acting as counterparty to market participants who hedge equities with long volatility positions - sellers of volatility collect premiums in calm markets but face large losses when volatility spikes.

Common implementational instruments include:

• Exchange-traded options and option spreads (straddles, calendar spreads, bull/bear spreads).
• VIX futures (futures on the 30-day S&P 500 implied volatility index in the U.S.).
• Over-the-counter (OTC) volatility swaps or variance swaps, providing near-pure exposures to variance or volatility (note: these are legally structured as forward contracts with payoffs linked to realised variance minus expected variance, multiplied by notional).

Investment Characteristics

The characteristics depend on position (long or short volatility) and instruments used. Short volatility strategies typically produce steady returns in calm markets but are exposed to large tail losses in volatility spikes. Long volatility positions have positive convexity and can provide powerful hedges with asymmetric payoffs. Liquidity depends on the chosen instruments; VIX futures and short-dated exchange-traded volatility options are relatively liquid, while bespoke OTC contracts are less so.

Role in a Portfolio

Long volatility strategies are effective diversifiers because equity volatility tends to be negatively correlated with equity returns. The cost of maintaining long volatility exposure is the premium paid to sellers in calm markets.

Reinsurance and Life Settlements

Some hedge funds invest in insurance-linked assets. Two common areas are life settlements and catastrophe reinsurance.

Life Settlements - Implementation and Characteristics

In a life settlement, an individual sells an existing life insurance policy to an investor (often via a broker). The investor pays the seller an agreed amount, then becomes responsible for future premium payments and receives the death benefit upon the insured's death. Investors seek policies where the purchase price is favourable, ongoing premiums are low, and the insured's life expectancy is shorter than actuarial averages used to price the policy in the market. Accurate alternative mortality estimates are essential to profitable life settlement investing. These investments are illiquid and require specialised actuarial and underwriting expertise.

Catastrophe Reinsurance

Catastrophe reinsurance involves taking on insurance risks (earthquakes, hurricanes, floods) transferred from insurers or reinsurers. Successful investment requires diversification across geography and peril types, adequate underwriting reserves, and premiums that compensate for tail risk. Catastrophe-linked securities may provide payoffs that are largely uncorrelated with financial markets.

Role in a Portfolio

Insurance-linked strategies generally provide returns with low correlation to market cycles; hence they can enhance portfolio diversification. Their illiquid nature and specialised operational needs must be considered in asset allocation.

LOS 34.g - Multi-Manager Strategies

Most investors invest across several hedge fund strategies rather than in a single fund. Multi-manager approaches assemble diversified hedge fund exposures and adjust holdings over time. Two common forms are funds-of-funds (FoF) and multi-strategy funds.

Fund-of-Funds (FoF)

An FoF invests in a portfolio of underlying hedge funds, each often pursuing different strategies. Benefits of FoFs include diversification, manager selection expertise, due diligence, strategic and tactical style allocation, possible currency hedging, portfolio-level leverage, improved liquidity for small investors, access to closed funds, economies of scale in monitoring, and research resources. Disadvantages include an additional layer of fees, limited transparency into underlying funds, lack of netting of performance fees across underlying funds, and potential principal-agent conflicts.

Investment Characteristics

Historically, individual hedge funds used a "2 and 20" fee model (2% management fee and 20% performance fee). FoFs often added another layer (for example, an additional management fee and performance fee), though FoF fees have become more negotiable. FoFs enable smaller investors to reach diversified hedge fund exposure with much lower capital than would be required to invest directly in many individual funds. Liquidity management is challenging because underlying funds may impose stricter redemption terms than the FoF can offer, creating potential mismatch and management complexity. Netting risk can lead to paying significant incentive fees to a few successful underlying managers even when overall FoF performance is poor.

Strategy Implementation

Typical FoF implementation steps:

1. Identify potential underlying hedge funds using databases and introductions.
2. Determine an appropriate strategic allocation across hedge fund styles.
3. Conduct manager selection combining top-down and bottom-up analysis.
4. For each strategy, evaluate several candidate managers.
5. Interview managers and review audit and offering materials.
6. Assess personnel, operations, and risk management capabilities.
7. Negotiate terms (fees, liquidity, side letters) where possible.
8. After investment, monitor funds for personnel changes, style drift, and operational issues.

FoFs may also implement tactical allocations by overweighting or underweighting certain styles relative to the strategic allocation.

Role in a Portfolio

By combining many uncorrelated or low-correlated hedge funds, an FoF can deliver diversification, smoother returns, lower volatility, and reduced dependence on any single manager's performance.

Multi-Strategy Hedge Funds

Multi-strategy funds pursue multiple strategies within a single firm and governance structure. The sub-strategies are managed in-house rather than by external managers as in FoFs. Multi-strategy funds aim to deliver steady, low-volatility returns through diversification across internal teams and strategies.

Investment Characteristics

Multi-strategy funds share some benefits with FoFs but differ operationally: operational risk is concentrated under a single organisation, possibly reducing operational diversification. Strategy diversity may be limited because in-house teams often share similar investment approaches. A key advantage is rapid tactical reallocation: capital can be redeployed among internal strategies quickly. Fee structures tend to be more attractive than FoFs because the fund can net performance internally and investors often pay incentive fees only on aggregate fund performance. Liquidity is managed via lock-ups and periodic redemption limits. Multi-strategy funds may use significant leverage, and during market stress such leverage can create left-tail blow-ups (examples cited historically include Ritchie Capital in 2005 and Amaranth Advisors in 2006).

Strategy Implementation

Capital is allocated across several in-house strategies, enabling both strategic and tactical allocation. Centralised risk management and shared operations produce operational efficiencies. Multi-strategy funds can adjust leverage and allocations more quickly than FoFs because of greater internal transparency.

Role in a Portfolio

Multi-strategy funds aim to provide diversification and steady returns. Historically, some multi-strategy funds have outperformed FoFs on a net-fee basis due to lower aggregated fees and greater tactical flexibility; however, concentrated leverage and correlated risks within a single operation can produce severe downside events during crises.

MODULE QUIZ 34.3

1. Considering global macro strategies and managed futures strategies, it would be most accurate to state that:
   • A. managed futures strategies use more discretionary approaches.
   • B. global macro strategies use more systematic approaches.
   • C. both strategies tend to be highly liquid and use high leverage.
2. During periods of market stress:
   • A. managed futures and global macro both exhibit right-tail skewness.
   • B. managed futures strategies exhibit left-tail skewness.
   • C. global macro strategies exhibit left-tail skewness.
3. Considering the correlation between equity volatility and equity market returns, the two measures are most likely to be:
   • A. highly positively correlated.
   • B. predominantly uncorrelated.
   • C. highly negatively correlated.
4. A hedge fund is most likely to purchase a pool of life insurance policies that has high:
   • A. surrender value.
   • B. ongoing premium payments.
   • C. likelihood of the insured person dying soon.
5. Compared to a multi-strategy fund, a fund-of-funds is most likely to offer the investor a more:
   • A. effective tactical asset allocation.
   • B. attractive fee structure.
   • C. diverse strategy mix.
6. Compared to a multi-strategy fund, a fund-of-funds is most likely to present an investor with higher:
   • A. transparency.
   • B. netting risks.
   • C. leverage.

MODULE 34.4: FACTOR MODELS AND PORTFOLIO IMPACT OF HEDGE FUNDS

LOS 34.h - Factor Models

Factor models quantify hedge fund risk exposures by explaining returns as a linear combination of systematic factors plus alpha and residual error. A conditional linear factor model extends this idea by allowing factor exposures or factor premia to change under different market regimes (for example, normal times versus crisis periods). Conditional models are useful because hedge funds often change behaviour in stressful markets (e.g., deleveraging, liquidity withdrawal), and a conditional model can help reveal these regime-dependent exposures.

A general conditional linear factor model

One commonly used representation for hedge fund returns is:

r_{i,t} = α_i + Σ_{k} β_{i,k} F_{k,t} + ε_{i,t}

where:

• r_{i,t} = return of hedge fund i in period t;
• α_i = fund-specific alpha (manager skill or omitted constant return component);
• β_{i,k} = exposure of fund i to factor k;
• F_{k,t} = return of factor k in period t;
• ε_{i,t} = idiosyncratic error term.

A conditional specification might allow β_{i,k} to differ when a market-stress indicator is active (for example, inclusion of interaction terms between factors and a crisis dummy variable), thereby capturing changes in exposures across regimes.

Example factor set

Hasanhodzic and Lo (2007) examined hedge fund returns using a larger set of candidate factors and then applied stepwise regression to avoid multicollinearity. They initially considered six factors:

• Equity risk (SNP500) - S&P 500 total return index;
• Interest rate risk (BOND) - Bloomberg Barclays Corporate AA Intermediate Bond Index;
• Currency risk (USD) - U.S. Dollar Index;
• Commodity risk (CMDTY) - GSCI total return;
• Credit risk (CREDIT) - Moody's Baa minus Aaa corporate bond yield spread;
• Volatility risk (VIX) - CBOE Volatility Index.

Using stepwise regression to reduce multicollinearity, BOND and CMDTY were dropped, leaving a four-factor model often referenced in the curriculum:

• Equity risk (SNP500)
• Currency risk (USD)
• Credit risk (CREDIT)
• Volatility risk (VIX)

Different hedge fund strategies will show varying exposures to these factors. For instance:

• Arbitrage strategies often exhibit exposure to credit spreads and volatility.
• Event-driven and L/S equity strategies typically show material equity (market beta) exposure.

Using conditional factor models helps investors and risk managers better understand how a hedge fund might perform in normal versus stressed markets and can reveal hidden exposures that traditional analyses might miss.

LOS 34.i - Portfolio Impact of Hedge Fund Allocations

Consider a traditional 60% equity / 40% bond portfolio. If 20% of total capital is reallocated to a hedge fund strategy, the resulting weights become 48% equities, 32% bonds, and 20% hedge fund (assuming a simple reweighting). Empirical studies and model analyses generally find:

• Total portfolio standard deviation typically decreases for many hedge fund allocations.
• Sharpe ratio increases, indicating improved risk-adjusted return.
• Sortino ratio increases, because downside variation is often reduced relative to returns.
• Maximum drawdown often decreases in many portfolios (approximately one-third of portfolios in some studies).

Risk-adjusted metrics should be selected carefully. The Sharpe ratio uses total standard deviation (both upside and downside volatility) as the risk measure. The Sortino ratio uses only downside deviation (below a threshold), which can be more appropriate for hedge funds because many strategies exhibit left-tail risk and asymmetric returns.

Which hedge fund strategies improve risk-adjusted performance?

Empirical results show that adding a 20% allocation to certain hedge fund strategies to a 60/40 portfolio tended to produce comparatively high Sharpe ratios. These strategies include:

• Systematic futures (managed futures).
• Distressed securities.
• Fixed-income arbitrage.
• Global macro.
• Equity market neutral.

The highest Sortino ratios were often associated with:

• Equity market neutral.
• Systematic futures.
• Long/short equity.
• Event-driven strategies.

By contrast, some strategies were observed to provide little enhancement to risk-adjusted performance when added to a traditional portfolio; notable examples include funds-of-funds and some multi-strategy implementations (often due to higher fees and less incremental diversification).

Risk Metrics - Standard Deviation and Drawdown

Standard deviation findings for portfolio combinations indicate that the following strategies often produce the greatest reduction in overall portfolio standard deviation:

• Dedicated short-biased
• Bear market neutral
• Systematic futures
• FoF: macro/systematic
• Equity market neutral

Strategies that did little to reduce portfolio standard deviation in some analyses include:

• Event-driven: distressed securities - outcome distributions are often skewed by occasional large successes or failures and tend to be long-biased.
• Relative value: convertible arbitrage - highly leveraged structures can be vulnerable in volatile markets, limiting their ability to reduce portfolio variance.

Drawdown measures peak-to-trough declines. Strategies that tended to show the smallest maximum drawdowns when added to a stock/bond portfolio included opportunistic strategies such as:

• Global macro
• Systematic futures
• Merger arbitrage
• Equity market neutral

The conditional risk model helps explain why: these strategies often have minimal exposure to credit risk and equity beta and typically hold liquid instruments which improve performance during crises. By contrast, long/short equity, distressed securities, and convertible arbitrage strategies may fail to mitigate drawdown because they retain elevated equity or credit exposure and can suffer during crisis periods.

MODULE QUIZ 34.4

1. Conditional linear factor models used to understand hedge fund risk exposures are most likely to use factors that include:
   • A. liquidity risk, operational risk, valuation risk, and systemic risk.
   • B. interest rate risk, commodity risk, margining risk, and concentration risk.
   • C. equity risk, credit risk, currency risk, and volatility risk.
2. Adding a 20% allocation of a hedge fund strategy to a traditional 60%/40% portfolio is most likely to increase the total portfolio's:
   • A. standard deviation.
   • B. maximum drawdown.
   • C. Sortino ratio.
3. The risk-adjusted performance of a traditional 60%/40% portfolio is most likely to be improved by adding an allocation to a hedge fund using the strategy of:
   • A. equity market neutral.
   • B. fund-of-funds.
   • C. multi-strategy.

KEY CONCEPTS

LOS 34.a - Classification Summary

• Hedge fund strategies are classified by instruments, investment philosophy, and principal risk exposures.
• The six categories used here are: Equity related, Event driven, Relative value, Opportunistic, Specialist, and Multi-manager.

LOS 34.b - Equity Strategies Summary

• Long/short equity - stock selection driven; typically liquid and net long; more market neutral approaches use higher leverage.
• Dedicated short / short-biased - negative correlation to traditional assets, modest return targets, minimal leverage; dedicated short typically 60%-120% short, short-biased typically 30%-60% net short.
• Equity market neutral (EMN) - seeks to profit from relative mispricings with minimal beta; usually quantitative; often uses substantial leverage.

LOS 34.c - Event-Driven Summary

• Merger arbitrage - profits from expected deal completion; relatively liquid; returns are insurance-like with high Sharpe but can have significant left-tail risk; managers often use leverage.
• Distressed securities - invest in troubled firms' securities; usually long-biased, illiquid, and uses moderate or low leverage; potential for higher returns but greater variability.

LOS 34.d - Relative Value Summary

• Fixed-income arbitrage - exploits bond mispricings and yield curve opportunities; commonly uses high leverage.
• Convertible arbitrage - attempts to extract underpriced implied volatility in convertibles while hedging with short equity; works best in liquid, moderately volatile markets with active convertible issuance; typical leverage examples include ~300% long bond exposure and ~200% short equity exposure.

LOS 34.e - Opportunistic Summary

• Opportunistic strategies tend to be highly liquid and may employ significant leverage.
• Global macro - discretionary, uses many instruments to exploit global trends; returns can be volatile and lumpy.
• Managed futures - systematic approaches trading futures across asset classes; tend to offer strong diversification benefits and right-tail skew in crises.

LOS 34.f - Specialist Summary

• Volatility trading - trades volatility term-structure and cross-market volatility differences using options, VIX futures, volatility or variance swaps; long volatility has positive convexity and can be a potent diversifier.
• Life settlements - purchase pools of life insurance contracts; profitability depends on low purchase price, low ongoing premiums, and accurate mortality/life-expectancy assessment.

LOS 34.g - Multi-Manager Summary

• Funds-of-funds (FoF) - invest across many hedge funds; provide broad diversification and manager selection but add another layer of fees and may have transparency and netting issues.
• Multi-strategy funds - run multiple strategies in-house; can reallocate capital quickly and offer better fee outcomes, but carry concentrated operational risk and potential left-tail leverage risk.

LOS 34.h - Factor Modelling Summary

Conditional linear factor models can quantify hedge fund exposures. A common four-factor set used in curriculum analysis includes equity, currency, credit, and volatility factors. Stepwise regression helps reduce multicollinearity when selecting factors.

LOS 34.i - Portfolio Impact Summary

Allocating around 20% to hedge funds within a 60/40 stock/bond portfolio often reduces total portfolio standard deviation, increases Sharpe and Sortino ratios, and, in many cases, decreases maximum drawdown - especially when allocations target strategies with low correlation to traditional assets such as systematic futures, equity market neutral, and global macro.

ANSWER KEY FOR MODULE QUIZZES

Module Quiz 34.1 - Answers

1. C - Convertible bond arbitrage strategies are generally classified as relative value strategies. (LOS 34.a)

2. A - Managed futures strategies are generally classified as opportunistic strategies. (LOS 34.a)

Module Quiz 34.2 - Answers

1. A - EMN strategies usually apply relatively high levels of leverage to produce meaningful returns. Dedicated short and short-biased strategies typically use little leverage. (LOS 34.b)

2. C - Gross exposures of ~80% long and ~35% short are characteristic of a long/short equity strategy. Dedicated short strategies are usually 60%-120% short; short-biased strategies typically are ~30%-60% net short. (LOS 34.b)

3. A - Compared to other hedging approaches, EMN strategies generally have relatively modest returns and derive returns primarily from alpha rather than beta. They are attractive in periods of market weakness. (LOS 34.b)

4. A - Distressed securities investing is usually long-biased. Illiquidity is high and leverage is generally moderate to low. (LOS 34.c)

5. A - In liquidation, senior secured debt is paid first, followed by junior secured debt, unsecured debt, convertible debt, preferred stock, and finally common stock. (LOS 34.c)

6. A - Convertible arbitrage managers typically go long convertible bonds and short equity to delta-hedge the embedded option risk. (LOS 34.d)

Module Quiz 34.3 - Answers

1. C - Managed futures typically use systematic approaches; global macro uses more discretionary approaches; both tend to be highly liquid and often use high leverage. (LOS 34.e)

2. A - Both managed futures and global macro strategies have historically exhibited right-tail (positive) skewness during some market stress periods; global macro outcomes are more heterogeneous across managers. (LOS 34.e)

3. C - Equity volatility is highly negatively correlated with equity market returns: volatility rises when markets fall, making long volatility strategies useful diversifiers. (LOS 34.f)

4. C - In life settlements, managers seek a high probability that the insured will die sooner than predicted, low purchase price relative to policy value, and low ongoing premiums. (LOS 34.f)

5. C - Funds-of-funds generally offer a more diverse strategy mix than multi-strategy funds. (LOS 34.g)

6. B - Compared with multi-strategy funds, funds-of-funds typically present higher netting risk (and less transparency). (LOS 34.g)

Module Quiz 34.4 - Answers

1. C - The discussed conditional factor model uses equity risk, credit risk, currency risk, and volatility risk as primary factors; interest rate and commodity factors were dropped for multicollinearity in the referenced analysis. (LOS 34.h)

2. C - Adding a 20% hedge fund allocation to a 60/40 portfolio usually decreases standard deviation and increases Sharpe and Sortino ratios; hence it typically increases the Sortino ratio. (LOS 34.i)

3. A - Adding an allocation to equity market neutral strategies has been shown effective in improving risk-adjusted performance; similar benefits have been observed for systematic futures, global macro, and some event-driven strategies. Fund-of-funds and multi-strategy funds often do not enhance risk-adjusted performance significantly after fees. (LOS 34.i)

TOPIC QUIZ: ALTERNATIVE INVESTMENTS

You have completed the Alternative Investments topic section. For further assessment, take the Topic Quiz available through your learning platform to test exam-style understanding and timing. Aim to allow approximately three minutes per question; a score below 70% signals the need for additional study.