Hedge Fund Strategies
READING 34
HEDGE FUND STRATEGIES
EXAM FOCUS
This reading describes some of the most important categories of hedge fund strategies, examines their common investment characteristics, and explains how these strategies are implemented. Understand the investment characteristics and implementation approach for six major hedge fund strategy categories. Be able to interpret the model for understanding the risk exposures of each of these strategies.
MODULE 34.1: OVERVIEW OF HEDGE FUND STRATEGIES
Introduction
Hedge funds represent an important subgroup of alternative investments. They are distinguished from traditional investments by a set of institutional, regulatory, and operational characteristics that permit a wider set of trading approaches and exposures.
Key features that commonly distinguish hedge funds from traditional investment vehicles include:
- Lower regulatory and legal constraints relative to mutual funds and other regulated products.
- Flexibility to use short selling and derivatives for hedging or to obtain exposures that are difficult to access otherwise.
- A larger investment universe-the freedom to invest across asset classes, securities, and jurisdictions.
- Aggressive investment exposures-including active trading and concentrated bets.
- Comparatively free use of leverage to amplify returns or exposures.
- Liquidity constraints for investors-lock-ups and limited redemption windows are common.
- Lack of transparency relative to public funds; underlying positions and risk exposures may be private.
- Higher cost structures-management fees plus incentive (performance) fees.
The central practical question for investors is whether the higher expense levels of hedge funds are justified by the return and diversification benefits that they can deliver. Some investors seek hedge funds primarily as a source of alpha (manager skill), which can be difficult to obtain persistently; others allocate to hedge funds to access specialised investment talent and to obtain exposures that are otherwise inaccessible.
LOS 34.a: Discuss how hedge fund strategies may be classified.
Classifications of Hedge Fund Strategies
Hedge fund strategies can be classified according to the instruments they invest in, the trading approach they use (top-down versus bottom-up, discretionary versus systematic), and the types of risk exposures they take. There are many possible taxonomies; this module organises strategies into six practical categories:
- Equity-related - strategies focused primarily on equities (e.g., long/short equity, dedicated short bias, equity market neutral).
- Event-driven - strategies that seek to profit from corporate events such as mergers, restructurings, bankruptcies, or other major firm-specific events (e.g., merger arbitrage, distressed securities).
- Relative value - strategies that exploit pricing differences between related securities, commonly in fixed income and hybrid instruments (e.g., fixed-income arbitrage, convertible bond arbitrage).
- Opportunistic - top-down strategies that span asset classes and adapt to market conditions (e.g., global macro, managed futures).
- Specialist - niche strategies that require specialised market expertise (e.g., volatility strategies, reinsurance/life settlements).
- Multi-manager - strategies that combine other hedge fund strategies or managers, including multi-strategy funds and funds-of-funds.
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
Video covering this content is available online.
LOS 34.b: Discuss investment characteristics, strategy implementation, and role in a portfolio of equity-related hedge fund strategies.
Equity-Related Hedge Fund Strategies
Equity-related hedge fund strategies focus primarily on stock markets; their primary source of risk is equity (market) risk. Major subtypes include long/short equity, dedicated short bias (or short-only), and equity market neutral.
Long/Short Equity
Long/short (L/S) equity funds purchase stocks expected to appreciate (long positions) and sell short stocks expected to decline (short positions). The mix of longs and shorts determines the portfolio's overall market exposure (beta).
Investment Characteristics
When long and short positions are combined, portfolio beta equals the weighted sum of the positive (long) and negative (short) betas of the holdings. L/S equity funds typically maintain a net long exposure rather than zero market exposure; a common target net exposure range is 40% to 60% net long, which reflects an expectation of upward market drift.
L/S managers often aim to produce returns comparable to long-only equity strategies but with lower portfolio standard deviation-ideally delivering similar returns with roughly half the volatility.
Strategy Implementation
Successful L/S implementation requires identifying underpriced and overpriced stocks, so many managers adopt a sector-specific or industry-focused approach where they can develop deep expertise. Managers may also use index futures or ETFs to obtain background market exposures. Funds that seek market-neutrality tend to use more leverage to achieve attractive absolute returns because their market beta is close to zero.
Role in a Portfolio
The principal objective of most L/S equity funds is to produce alpha through stock selection while retaining a moderate net long beta to benefit from general market appreciation. Analysts evaluating L/S funds should weigh the expected alpha net of fees and consider whether a cheaper long-only exposure might meet investment goals equally well.
Dedicated Short Selling and Short-Biased
Dedicated short-selling funds maintain predominantly short positions, seeking securities they consider overvalued. Short-biased funds also maintain net short exposure but offset it partially with long positions (and often cash).
Short strategies face the structural challenge that market prices tend to rise over long horizons, which negatively biases short returns. A prominent variant is activist short selling, where the manager not only shorts the stock but publicly presents research arguing that the company is overvalued.
Investment Characteristics
Short-biased and dedicated short-selling funds seek negative correlation with conventional long-only assets and thus can provide diversification. Expected returns tend to be modest and volatility can be relatively high compared with some other hedge fund strategies.
Strategy Implementation
Short selling is executed by borrowing a security and selling it at the market price, with the obligation to repurchase and return it later. Profit results if the stock falls and can be repurchased more cheaply. Managers use detailed bottom-up fundamental analysis to identify companies with weak business models, poor management, excessive leverage, shrinking markets, or accounting problems.
A dedicated short seller holds only short positions-typical gross short exposures may run from 60% to 120% short; such managers often hold cash to reduce net market exposure. Short-biased managers might be 30% to 60% net short, using modest leverage; both approaches typically use relatively little leverage overall.
Role in a Portfolio
The main attraction of these strategies is diversification through negative or low correlation to conventional portfolio returns. The trade-off is lower expected returns and greater volatility relative to some other hedge fund strategies.
Equity Market Neutral (EMN)
Equity market-neutral strategies aim for near-zero net market exposure by balancing long and short equity positions so that the weighted betas sum to zero; alpha is intended to arise from relative mispricings.
Investment Characteristics
Because EMN strategies hedge away market beta, their returns tend to be modest in absolute size but exhibit low volatility and low correlation with market movements. These funds can provide significant diversification benefits and perform relatively well during market downturns.
Strategy Implementation
Managers take long positions in undervalued stocks and short positions in overvalued stocks. EMN funds can be implemented either discretionarily (manager judgement) or via quantitative rules. To produce attractive returns with little or no market beta, EMN funds typically use leverage.
Common EMN subtypes include:
- Pairs trading: trade two co-integrated stocks that normally move together; profit from unusually large divergences as they revert.
- Stub trading: long and short positions in a subsidiary and its parent according to ownership percentages.
- Multi-class trading: long and short mispriced share classes of the same firm (e.g., voting vs non-voting shares).
Other instruments such as options, stock index futures, and other derivatives can be used to construct zero-beta exposures.
Role in a Portfolio
EMN funds attempt to deliver alpha without market beta risk, resulting in low-volatility, low-correlated returns. They are particularly useful diversifiers, especially when markets are volatile or declining.
LOS 34.c: Discuss investment characteristics, strategy implementation, and role in a portfolio of event-driven hedge fund strategies.
Event-Driven Strategies
Event-driven strategies seek to profit from correctly predicting the outcomes of corporate events-mergers, acquisitions, reorganisations, bankruptcies, spin-offs, asset sales, governance changes, and similar events. These strategies take positions in securities of the target firms or related instruments. A distinction is made between:
- Soft-catalyst investing: investments made before an event is announced (higher volatility and risk).
- Hard-catalyst investing: investments made after an event is announced, seeking to exploit incomplete price adjustments.
The principal risk is event risk: the chance that the event does not occur as expected (for example, a merger failing or a bankruptcy outcome being different than anticipated). The two event-driven strategies examined here are merger arbitrage and distressed securities.
Merger Arbitrage
Merger arbitrage attempts to earn returns from the spread between the price of target and acquirer securities between announcement and deal completion. It is sometimes analogised to selling insurance on the success of a corporate transaction: the manager receives a premium if the deal completes and pays out if the deal fails.
Investment Characteristics
If a merger fails, price movements reverse: the target tends to fall and the acquirer may rise, producing significant losses for a manager positioned for success-losses can be severe, on the order of a large percentage of the position (for example, a 40% loss in extreme cases). Therefore, merger arbitrage has material left-tail risk.
Merger arbitrage strategies tend to be relatively liquid compared with many other hedge fund approaches.
Strategy Implementation
In a stock-for-stock deal, common implementation is to buy the target's shares and short the acquirer's shares, profiting when the exchange ratio is realised at deal completion. If a manager expects a deal to fail, positions are reversed. To generate attractive returns from generally small spreads, merger arbitrage funds frequently employ substantial leverage-typical leverage levels cited are 300% to 500%. Cross-border M&A transactions add complexity and regulatory risk because two countries and regulatory regimes are involved, increasing the perceived risk.
Role in a Portfolio
Merger arbitrage often produces steady, insurance-like returns and high Sharpe ratios but carries significant left-tail risk should multiple deals fail or a large deal break down.
Distressed Securities
Distressed securities strategies invest in securities of companies experiencing financial distress or bankruptcy. The securities trade at steep discounts, often creating opportunities when institutional investors face restrictions on holding non-investment-grade assets and sell down positions, producing pricing inefficiencies.
Outcomes for distressed positions depend on the recovery process. In liquidation, assets are sold and proceeds are distributed by seniority: senior secured debt → junior secured debt → unsecured debt → convertible debt → preferred stock → common stock. Alternatively, a reorganisation (restructuring) may convert debt to equity or extend maturities, which alters recovery prospects.
Investment Characteristics
Distressed strategies typically produce higher average returns than many other event-driven strategies but with greater variability and illiquidity. Lock-up periods for investors are often long because it may take considerable time to resolve distressed situations-investors commonly accept limited redemption rights for extended periods (sometimes no redemptions for the first two years).
Strategy Implementation
Implementation ranges from passive purchases of distressed securities to activist approaches where managers accumulate control positions in a particular class of claims to influence bankruptcy negotiations. Distressed investing requires expertise in legal, restructuring, and bankruptcy procedures. Most distressed investments are long positions; shorting distressed securities is possible but less common. Leverage use is generally low.
Role in a Portfolio
Distressed strategies are illiquid and sensitive to market downturns; they can nonetheless offer higher expected returns and diversification because their outcomes depend on firm-specific restructurings rather than market-wide drivers.
LOS 34.d: Discuss investment characteristics, strategy implementation, and role in a portfolio of relative value hedge fund strategies.
Relative Value Hedge Fund Strategies
Relative value strategies exploit valuation differences between related securities; they commonly trade fixed-income instruments and hybrid securities such as convertibles. Expected returns emanate from earning liquidity, credit, and volatility premia as prices converge; however, turbulent market conditions can produce large losses. Two important relative value strategies are fixed-income arbitrage and convertible bond arbitrage.
Fixed-Income Arbitrage
Fixed-income arbitrage seeks to profit from temporary mispricing among bonds and other fixed-income instruments by buying undervalued issues and shorting overvalued ones. Opportunities include exploiting yield curve anomalies or anticipating changes in yield curve shape.
Instruments used range from consumer and corporate debt to bank loans and sovereign bonds. Because mispricings are typically small and fixed-income markets are relatively efficient, managers commonly employ significant leverage to obtain meaningful returns.
Strategy Implementation
Two representative types of fixed-income arbitrage are:
- Yield curve trades: form a view on how the yield curve will steepen or flatten and take long and short positions across maturities to profit from the anticipated change. Risk sources include interest-rate movements, credit risk, and liquidity when securities are from different issuers.
- Carry trades: short low-yielding securities and go long high-yielding securities to earn the yield differential plus potential spread convergence.
Investment Characteristics
Because bond markets price efficiently, profit opportunities are modest, driving managers to use high leverage; leverage levels of 400% or even up to 1,500% have been reported in extreme cases. Liquidity varies by instrument: U.S. Treasuries are very liquid; mortgage-backed securities, emerging-market sovereigns, and other specialised instruments are less so.
Role in a Portfolio
Fixed-income arbitrage yields distributions that can resemble the payoff from writing puts: steady income from spread convergence and carry, with substantial losses if spreads widen unexpectedly. The heavy leverage makes these strategies vulnerable to margin calls and forced deleveraging, which can cascade-as observed in historical crises such as the 1997 Asian Financial Crisis and the 1998 collapse of Long-Term Capital Management.
Convertible Bond Arbitrage
Convertible bonds are bonds that pay coupons and give the holder the right to convert into a predetermined number of common shares at specified times. A convertible can be viewed conceptually as a straight bond plus a long call option on the issuer's stock.
Convertible arbitrage seeks to exploit the implied volatility embedded in convertibles, which is often underpriced relative to the historical volatility of the underlying equity. Managers hedge the delta and gamma exposures of the embedded option to isolate the volatility premium while managing market, interest-rate, and credit risks.
Investment Characteristics
Convertible arbitrage faces two principal liquidity challenges: shorting the underlying equity (which can be costly or limited) and holding complex fixed-income hybrids that are less liquid than plain-vanilla bonds.
Strategy Implementation
Managers long convertible bonds and short the underlying equity to hedge directional market exposure. The behaviour of a convertible depends on moneyness:
- When conversion price ≫ current stock price, the convertible behaves like a bond (call is deep out-of-the-money; delta ≈ 0).
- When conversion price ≪ current stock price, the convertible behaves like stock (call is deep in-the-money; delta ≈ 1).
Significant leverage is used; a typical example allocation might be 3× long bond exposure and 2× short equity exposure, with the smaller short equity exposure reflecting delta hedging of the embedded call.
Role in a Portfolio
Convertible arbitrage performs best in normal market conditions with adequate liquidity, modest volatility, and active issuance of convertibles. During credit stress or illiquidity, convertible strategies can underperform.
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
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LOS 34.e: Discuss investment characteristics, strategy implementation, and role in a portfolio of opportunistic hedge fund strategies.
Opportunistic Hedge Fund Strategies
Opportunistic strategies take a top-down view across global markets and asset classes; they adapt to macroeconomic and market conditions and employ a variety of trading techniques. Implementation may be:
- Systematic: rules-based and algorithmic (often used in managed futures).
- Discretionary: manager judgement and fundamental macro analysis (often used in global macro).
Techniques include technical analysis (price-based signals) and fundamental analysis (economic and financial data). Two opportunistic strategies discussed here are global macro and managed futures.
Global Macro Strategies
Global macro managers forecast macroeconomic variables-inflation, exchange rates, yield curve movements, central bank policy, and country economic health-and take positions across asset classes to profit from their views.
Investment Characteristics
Global macro managers can take directional positions (e.g., long assets expected to benefit from rising rates) or thematic positions (e.g., invest in firms likely to benefit from a trade agreement). Mean-reverting, low-volatility markets are generally unfavourable for global macro; the strategy performs best when significant trends or macro dislocations are present. Returns are often uneven and can be volatile because forecasts can be incorrect or events may evolve unpredictably.
Strategy Implementation
Global macro is a top-down approach beginning with the global economy and narrowing to specific trades. Managers vary in their use of technical versus fundamental information and in discretionary versus systematic implementation. Many global macro funds employ leverage; leverage levels of 600% to 700% of fund assets are referenced as common in some implementations. Directional managers rely more on fundamental analysis; relative-value global macro managers compare valuations across securities.
Role in a Portfolio
Global macro funds can add alpha and diversification when combined with traditional assets. They may anticipate regime shifts (for example, correctly anticipating the U.S. subprime crisis) and generate returns that are beneficial during stress periods, sometimes exhibiting right-tail returns during turmoil, though this outcome cannot be guaranteed.
Managed Futures
Managed futures funds trade futures, forwards, options on futures, swaps, and sometimes currencies and commodities. They primarily use derivatives rather than outright purchases of the underlying assets.
Investment Characteristics
Because futures require only margin rather than full cash payment, managed futures funds can achieve large exposures with small collateral (for example, using 1/8 of capital as initial margin). The remainder of capital is typically held in highly liquid instruments (e.g., short-term government bonds) and can also serve as collateral. Futures markets are extremely liquid and trade globally and continuously.
A drawback is that crowded strategies and common signals can produce herding and execution slippage when many participants attempt similar trades.
Strategy Implementation
Managed futures are frequently implemented using momentum-based rules:
- Time-series momentum (TSM): buy assets that have shown positive returns over a lookback period and short those with negative returns.
- Cross-sectional momentum (CSM): within an asset class, go long the strongest performers and short the weakest performers.
Managers use volatility and momentum signals to trigger trades and have explicit rules for exits (price targets, momentum reversal, time-based exits, trailing stop-losses, or combinations). Positions are sized according to volatility and correlations to control risk. Because many managers use similar rules and signals, historical profitability can decline as signals become crowded.
Role in a Portfolio
Managed futures typically have low correlation with traditional equities and bonds, improving portfolio risk-adjusted returns. In periods of stress, managed futures have tended to produce right-skewed returns, making them valuable diversifiers when other strategies may suffer negative skewness.
LOS 34.f: Discuss investment characteristics, strategy implementation, and role in a portfolio of specialist hedge fund strategies.
Specialist Strategies
Specialist strategies operate in market niches relying on specialised knowledge to seek uncorrelated, high risk-adjusted returns. Two specialist strategies considered here are volatility trading and reinsurance/life settlements.
Volatility Trading
Volatility trading focuses on trading instruments whose payoffs depend on expected or realised volatility. Managers trade volatility across geographies and asset classes-buying underpriced volatility and selling overpriced volatility.
Examples of relative volatility pricing include regional differences in implied volatility; for instance, implied volatility in Tokyo has historically been cheaper than in New York even though realised volatility may be higher in Tokyo.
A common trade is to sell volatility to earn an insurance-like premium; however, selling volatility carries the risk of large losses if realised volatility spikes. In U.S. markets, the VIX index (30-day implied volatility of the S&P 500) is commonly used; VIX futures tend to be mean reverting.
Strategy Implementation
Volatility can be traded using:
- Exchange-traded options (straddles, vertical spreads, calendar spreads).
- Over-the-counter (OTC) customised options (introduces counterparty and liquidity risk).
- VIX futures, which are a direct but somewhat imperfect way to gain exposure to equity implied volatility.
- OTC volatility swaps or variance swaps, which provide near-pure exposure to volatility (note that these named "swaps" often behave like forwards whose payoff is based on realised variance versus expected variance multiplied by notional).
Investment Characteristics
Characteristics depend on instruments and positioning. Short-volatility positions generally collect premiums and perform steadily in normal markets; long-volatility positions display positive convexity and can be valuable hedges. Liquidity varies: VIX futures and short-dated exchange-traded volatility options are highly liquid; OTC volatility instruments are less liquid. Futures mechanics make it straightforward to apply leverage to volatility trades. Long-volatility exposures can produce large gains from small probabilities of extreme moves.
Role in a Portfolio
Long volatility strategies act as potent diversifiers because equity volatility and equity returns are strongly negatively correlated; the cost of maintaining long-volatility insurance is the premium paid for the position.
Reinsurance / Life Settlements
Hedge funds have increasingly participated in insurance-related investments:
- Life settlements: a policyholder sells an in-force life insurance policy to an investor (often via a broker); the investor pays the policy premiums and collects the death benefit when the insured dies.
- Catastrophe reinsurance: insurers transfer catastrophe risk (earthquakes, hurricanes, floods, etc.) to reinsurers; reinsurers and investors (including hedge funds) may purchase reinsurance or insurance-linked securities to accept such risks.
Investment Characteristics
Insurance investments are typically illiquid since policies and reinsurance contracts are not easily traded after initiation.
Strategy Implementation
For life settlements, hedge funds evaluate pools of policies available through brokers and select those expected to generate attractive returns. The investment succeeds if the present value of future insurance payouts exceeds the present value of premiums and other costs paid by the fund. Managers seek policies with:
- Low purchase price relative to death benefit.
- Low ongoing premium payments required by the investor.
- High probability that the insured will die relatively soon (relative to actuarial expectations).
Accurate alternate estimates of life expectancy are crucial; assessing pools requires actuarial expertise and careful due diligence.
Role in a Portfolio
Insurance investments are attractive for diversification because their returns are largely uncorrelated with financial markets and business cycles-natural catastrophes and insured mortality are typically independent of market returns. When structured and diversified properly, reinsurance and life settlements can add alpha and diversification.
LOS 34.g: Discuss investment characteristics, strategy implementation, and role in a portfolio of multi-manager hedge fund strategies.
Multi-Manager Hedge Fund Strategies
Rather than investing in a single strategy or manager, many investors allocate to multiple hedge fund strategies or managers to achieve diversification and to access specialised skills. Two common multi-manager approaches are funds-of-funds (FoF) and multi-strategy funds.
Fund-of-Funds (FoF)
A fund-of-funds pools investor capital and allocates it among a number of underlying hedge funds, typically each pursuing a different strategy. FoFs provide several potential benefits:
- Diversification across multiple hedge fund strategies.
- Expertise in manager selection and due diligence.
- Strategic and tactical style allocation.
- Currency hedging when needed.
- Portfolio-level leverage and possible access to closed managers.
- Economies of scale in monitoring and operational oversight.
- Potential concessions from underlying funds due to the FoF's size.
- Relatively better investor liquidity compared with directly investing in some underlying hedge funds.
Disadvantages of FoFs include:
- A second layer of fees for the investor (fees on top of fees).
- Limited transparency into each underlying fund.
- No netting of performance fees across underlying managers, producing netting risk.
- Additional principal-agent issues between the FoF manager and investors.
Investment Characteristics
Historically, individual hedge funds charged a "2 and 20" fee structure (2% management fee and 20% performance fee). FoFs typically added another layer (for example, an additional ~1% management fee and ~20% incentive fee), though these fees have become negotiable and generally smaller in recent years.
FoFs make hedge fund investing feasible for smaller investors by aggregating capital and providing diversified access: while direct minimums in underlying funds might be large (e.g., US$1 million), an FoF may offer a diversified hedge fund portfolio for much smaller investments (e.g., US$100,000). FoFs also alleviate the burden of conducting due diligence on many individual funds.
Liquidity management can be challenging for FoFs because the underlying funds may impose stricter redemption terms; FoF managers must manage this mismatch and investor expectations.
FoFs face netting risk: investors may pay high performance fees to a few successful underlying managers even if the FoF's overall performance is weak.
Strategy Implementation
A typical FoF implementation process includes:
- Using fund databases and personal introductions to identify available hedge funds.
- Setting a strategic allocation across hedge fund styles.
- Applying top-down and bottom-up selection techniques to identify candidates for each strategy allocation.
- Interviewing candidate managers and reviewing supporting materials (audits, operational processes, personnel, risk management).
- Negotiating terms such as fees, liquidity, and side letters.
- Ongoing monitoring for personnel changes, style drift, operational issues, and performance.
FoF managers may also implement tactical tilts by underweighting or overweighting strategies relative to their strategic allocation as market conditions change.
Role in a Portfolio
By combining multiple uncorrelated hedge funds, a FoF can produce steady returns, reduce idiosyncratic manager risk, and lower portfolio volatility relative to single-manager allocations.
Multi-Strategy Hedge Funds
Multi-strategy funds allocate capital among a number of strategies run within the same organisation rather than investing externally. The objective is to produce steady, low-volatility returns via internal diversification.
Investment Characteristics
Multi-strategy funds aim for diversification but concentrate operational processes under one roof, which reduces diversification of operational risk relative to FoFs. Managers within the same multi-strategy firm may also share similar investment views, limiting the effective diversity of approaches. Advantages include rapid tactical reallocations: because strategies are managed in-house, capital and leverage can be shifted quickly between strategies as opportunities arise. Fee structures are often more attractive than FoFs because multi-strategy funds can internalise netting risk and charge incentive fees on aggregate performance rather than on each sub-strategy separately.
Multi-strategy funds frequently use leverage and may have more varied performance than FoFs; excessive leverage and correlated exposures can produce left-tail blow-ups during stress (examples include Ritchie Capital in 2005 and Amaranth Advisors in 2006).
Strategy Implementation
Implementation involves allocating capital among multiple internal teams or sub-strategies and dynamically reallocating across them. Risk management benefits from having transparency into correlations and common risk drivers across sub-strategies. Shared administrative resources produce operational efficiencies.
Role in a Portfolio
Multi-strategy funds seek to improve overall portfolio diversification and deliver steady low-volatility returns. Historically they have sometimes outperformed FoFs due to better fee economics and quicker tactical management, but the leveraged nature of multi-strategy funds can present systemic left-tail risks during periods of market stress.
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
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LOS 34.h: Describe how factor models may be used to understand hedge fund risk exposures.
Factor Models - Analysis of Hedge Fund Strategies
One useful approach to quantify hedge fund risk exposures is a conditional linear factor model. A conditional model recognises that a fund's behaviour can change between normal market conditions and crisis periods (for example, the 2007-2009 global financial crisis). Estimating a fund's actual risk exposures helps investors understand where hidden vulnerabilities may lie and can help avoid widespread fund closures when crises occur.
Hasanhodzic and Lo (2007) proposed a multi-factor framework. They began with a larger set of candidate factors and used stepwise regression to select those factors that best explained returns while avoiding multicollinearity. The authors 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): Goldman Sachs Commodity Index (GSCI) total return.
- Credit risk (CREDIT): spread between Moody's Baa and Aaa corporate bond yields.
- Volatility risk (VIX): CBOE Volatility Index (VIX).
Using a stepwise selection procedure to mitigate multicollinearity, the BOND and CMDTY factors were dropped in the authors' estimation. The retained four-factor model included:
- Equity risk (SNP500).
- Currency risk (USD).
- Credit risk (CREDIT).
- Volatility risk (VIX).
Different hedge fund strategies exhibit distinct exposures to these factors. For example, arbitrage strategies are often exposed to credit spreads and volatility, while event-driven and long/short equity strategies typically show significant market beta exposure.
Professor's Note: the curriculum refers to this framework variously as a "factor model," "linear factor model," or "conditional risk model"-these terms refer to the same conditional linear factor modelling concept.
LOS 34.i: Evaluate the impact of an allocation to a hedge fund strategy in a traditional investment portfolio.
Portfolio Contribution of Hedge Fund Strategies
Consider reallocating 20% of a conventional 60% equity / 40% bond portfolio to a hedge fund strategy. The new weights become 48% equities, 32% bonds, and 20% hedge fund.
Empirical findings reported in the reading indicate that adding 20% allocations to many hedge fund strategies usually:
- Decreases total portfolio standard deviation.
- Increases the portfolio's Sharpe ratio.
- Increases the Sortino ratio.
- Decreases maximum drawdown in approximately one-third of portfolios.
These results suggest hedge funds often improve risk-adjusted returns and add diversification to traditional stock/bond portfolios.
Risk-Adjusted Performance
The Sharpe ratio measures excess return per unit of total volatility (standard deviation). Because Sharpe considers both upside and downside volatility, it can penalise funds that have large upside variation.
The Sortino ratio is an alternative that uses downside deviation as the risk metric, focusing on harmful volatility below a target return. Because many hedge fund strategies have asymmetric left-tail risk, the Sortino ratio is often a more informative measure.
Reported results show that adding a 20% hedge fund allocation to a 60/40 portfolio produced particularly high Sharpe ratios for allocations to:
- Systematic futures.
- Distressed securities.
- Fixed-income arbitrage.
- Global macro.
- Equity market neutral.
The highest Sortino ratios were attained via allocations to:
- Equity market neutral.
- Systematic futures.
- Long/short equity.
- Event-driven strategies.
Strategies identified as improving risk-adjusted performance (high Sharpe and Sortino) included systematic futures, equity market neutral, global macro, and event-driven approaches. In contrast, fund-of-funds and multi-strategy allocations were found not to materially enhance risk-adjusted returns in the study cited.
Risk Metrics
Investors allocate to hedge funds partly to reduce portfolio risk. Empirical findings highlighted:
Lowest portfolio standard deviations were associated with strategies such as:
- Dedicated short-biased strategies.
- Bear market neutral strategies.
- Systematic futures.
- FoF: macro/systematic allocations.
- Equity market neutral.
Strategies that had less impact in reducing standard deviation included:
- Event-driven: distressed securities (these are usually long biased and outcomes are binary: significant recovery or significant loss).
- Convertible arbitrage (leverage can become a liability during heightened volatility).
Drawdown
Drawdown is the peak-to-trough decline expressed as a percentage, and the high-water mark is the historical maximum portfolio value. Drawdown is useful to compare downside risk across strategies.
The smallest maximum drawdowns were observed for opportunistic strategies such as:
- Global macro.
- Systematic futures.
- Merger arbitrage.
- Equity market neutral.
These strategies tend to have minimal exposure to credit and equity risk and are generally liquid, helping them perform relatively well during crises. Strategies that did little to mitigate maximum drawdown included long/short equity, event-driven distressed, and convertible arbitrage-these have material equity and crisis-period credit exposures.
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
Hedge fund strategies are classified by the instruments they invest in, the investment philosophy followed, and the types of risk exposures taken. This reading organises strategies into six categories: equity-related, event-driven, relative value, opportunistic, specialist, and multi-manager.
LOS 34.b
Long/short equity generates alpha through stock selection; L/S funds are typically liquid and generally net long. Market-neutral approaches require greater use of leverage. Dedicated short-selling and short-biased strategies target negative correlations to traditional assets and aim for modest returns using minimal leverage; dedicated short positions can be 60%-120% short, short-biased funds typically around 30%-60% net short. Equity market neutral targets alpha from relative mispricings with minimal beta, is often quantitative, and commonly uses leverage.
LOS 34.c
Merger arbitrage seeks to profit from takeover spreads; returns are often steady but with left-tail risk if deals fail-some leverage is typical and liquidity is relatively high. Distressed securities invests in companies in bankruptcy or severe financial stress; strategies are usually long-biased, illiquid, and use moderate or low leverage. Returns for distressed investing are often higher than for other event-driven approaches but are unpredictable.
LOS 34.d
Fixed-income arbitrage exploits bond mispricings, including yield-curve and carry trades, and often uses high leverage. Convertible arbitrage extracts underpriced implied volatility of convertibles, hedging delta and gamma by shorting equity; convertible arbitrage typically benefits from active convertible issuance, liquidity, and modest volatility. Typical leverage profiles might be around 300% long bonds and 200% short equities (reflecting delta hedging).
LOS 34.e
Opportunistic strategies are generally liquid and may use high leverage. Global macro tends to be discretionary and uses a range of instruments to exploit cross-country and cross-asset trends. Managed futures use systematic approaches to trade futures across asset classes and often exhibit right-tail skewness in crisis periods.
LOS 34.f
Specialist strategies require niche expertise. Volatility traders trade options, VIX futures, volatility swaps, and variance swaps to express views on volatility term structures. Life settlements invest in pools of life insurance contracts, favouring policies with low surrender value, low ongoing premiums, and a high probability of imminent payout relative to actuarial averages.
LOS 34.g
Multi-manager approaches use diversification of strategies to deliver steady, low-volatility returns. Funds-of-funds offer a broad strategy mix but suffer from a second layer of fees, slower tactical execution, and netting risk. Multi-strategy funds combine multiple strategies in-house, providing quicker tactical reallocation and often better fee economics, but concentrate operational risk under one organisation.
LOS 34.h
Conditional linear factor models help quantify hedge fund exposures to systematic risk factors. The curriculum focuses on a four-factor model including equity risk, currency risk, credit risk, and volatility risk (the BOND and CMDTY factors were dropped in the cited stepwise selection due to multicollinearity).
LOS 34.i
Allocating a portion of a stock/bond portfolio to hedge funds generally provides diversification benefits and can improve risk-adjusted returns. A 20% allocation to hedge funds in a 60% equity / 40% bond portfolio typically reduces total standard deviation, increases Sharpe and Sortino ratios, and often reduces maximum drawdown.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 34.1
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
1. A EMN strategies usually apply somewhat high levels of leverage in order to produce meaningful levels of return. Neither dedicated short strategies nor short-biased strategies typically make significant use of leverage. ((<>)LOS 34.b)
2. C Equity long/short strategies typically have gross exposures of 70% to 90% long and 20% to 50% short. Dedicated short strategies are usually 60% to 120% short at all times. Short-biased strategies are usually around 30% to 60% net short. ((<>)LOS 34.b)
3. A Compared to various other hedge fund approaches, EMN strategies generally have relatively modest returns. EMN funds' primary source of return is alpha. They do not take on beta risk. Their lack of market exposure make EMN strategies attractive in periods of market weakness. ((<>)LOS 34.b)
4. A While short positions are possible in distressed securities investing, this strategy is usually long biased. Illiquidity tends to be high, and the strategy generally uses moderate to low leverage. ((<>)LOS 34.c)
5. A When a firm's assets are sold off in liquidation, securities holders are paid sequentially depending on the priority of their claims: first senior secured debt, then junior secured debt, unsecured debt, convertible debt, preferred stock, and lastly common stock. ((<>)LOS 34.c)
6. A Convertible arbitrage managers typically attempt to extract underpriced implied volatility from holdings of long convertible bonds. To delta and gamma hedge these exposures, the managers will take short equity positions. ((<>)LOS 34.d)
Module Quiz 34.3
1. C Managed futures strategies are usually implemented via systematic approaches, while global macro strategies more often use discretionary approaches. Both strategies typically use high leverage and tend to be highly liquid. ((<>)LOS 34.e)
2. A Returns of managed futures and global macro strategies both typically exhibit right-tail (positive) skewness during times of market stress. Global macro (<>)strategies, however, generally deliver more heterogeneous outcomes. (LOS 34.e)
3. C Equity volatility is roughly 80% negatively correlated with equity market returns: volatility levels rise when equity markets fall. This characteristic makes long volatility strategies useful diversifiers for long equity investments. ((<>)LOS 34.f)
4. C In implementing life settlement strategies, a hedge fund manager looks for policies with the following traits: low surrender value being offered to the insured individual, low ongoing premium payments required of the investor, and high probability that the insured person will die sooner than predicted by actuarial methods. ((<>)LOS 34.f)
5. C Funds-of-funds generally offer a more diverse strategy mix than do multi-strategy funds. Multi-strategy funds offer quicker tactical asset allocation and generally a better fee structure (for example, netting risk between strategies is often absorbed by the multi-strategy general partner). ((<>)LOS 34.g)
6. B Compared to multi-strategy funds, funds-of-funds offer an investor less transparency and higher netting risk. Multi-strategy funds exhibit higher variance due to less diverse strategies and use comparatively higher leverage. ((<>)LOS 34.g)
Module Quiz 34.4
1. C This reading uses a model that incorporates four factors: equity risk, credit risk, currency risk, and volatility risk. (The interest rate risk "BOND" and commodity risk "CMDTY" factors used by Hasanhodzic and Lo were dropped due to multicollinearity issues.) ((<>)LOS 34.h)
2. C Adding a 20% hedge fund allocation to a traditional 60%/40% portfolio usually decreases total portfolio standard deviation while it increases Sharpe
and Sortino ratios in the combined portfolios. An allocation to hedge funds often decreases maximum drawdown. ((<>)LOS 34.i)
3. A Adding an allocation to equity market-neutral hedge fund strategies to a traditional portfolio has been shown to be effective in generating superior risk-adjusted performance, as evidenced by high Sharpe and Sortino ratios. (The same is true of systematic futures, global macro, and event-driven strategies.) On the other hand, fund-of-funds and multi-strategy funds have been found not to enhance risk-adjusted performance significantly. ((<>)LOS 34.i)
Topic Quiz: Alternative Investments
You have now finished the Alternative Investments topic section. Please log into your Schweser online dashboard and take the Topic Quiz on this section. The Topic Quiz provides immediate feedback on how effective your study has been for this material. Questions are more exam-like than typical Module Quiz or QBank questions; a score of less than 70% indicates that your study likely needs improvement. These tests are best taken timed; allow three minutes per question.
