HF Strategies
INTRODUCTION AND CLASSIFICATION OF HEDGE FUND STRATEGIES
Learning Outcome
discuss how hedge fund strategies may be classified
Hedge funds form an important subset of the alternative investments opportunity set, but they come with many pros and cons in their use and application across different asset classes and investment approaches. The basic tradeoff is whether the added fees typically involved with hedge fund investing result in sufficient additional alpha and portfolio diversification benefits to justify the high fee levels. This is an ongoing industry debate.
Some argue that investing in hedge funds is a key way to access the very best investment talentâthose individuals who can adroitly navigate investment opportunities across a potentially wider universe of markets. Others argue that hedge funds are important because the alpha that may be produced in down markets is hard to source elsewhere.
The arguments against hedge funds are also non-trivial. In addition to the high fee levels, the complex offering memorandum documentation needs to be understood by investors (i.e., the limited partners). Other issues include lack of full underlying investment transparency/attribution, higher cost allocations associated with the establishment and maintenance of the fund investment structures, and generally longerâlived investment commitment periods with limited redemption availability.
In addition, each hedge fund strategy area tends to introduce different types of added portfolio risks. For example, to achieve meaningful return objectives, arbitrage-oriented hedge fund strategies tend to utilize significant leverage that can be dangerous to limited partner investors, especially during periods of market stress. Long/short equity and event-driven strategies may have less beta exposure than simple, long-only beta allocations, but the higher hedge fund fees effectively result in a particularly expensive form of embedded beta. Such strategies as managed futures or global macro investing may introduce natural benefits of asset class and investment approach diversification, but they come with naturally higher volatility in the return profiles typically delivered. Extreme tail risk in portfolios may be managed with the inclusion of relative value volatility or long volatility strategies, but it comes at the cost of a return drag during more normal market periods. In other words, some hedge fund strategies may have higher portfolio diversification benefits, while others may simply be return enhancers rather than true portfolio diversifiers.
Also, the hedge fund industry continues to evolve in its overall structure. Over the past decade, traditional limited partnership formats have been supplemented by offerings of liquid alternatives (liquid alts)âwhich are mutual fund, closed-end fund, and ETF-type vehicles that invest in various hedge fund-like strategies. Liquid alts are meant to provide daily liquidity, transparency, and lower fees while opening hedge fund investing to a wider range of investors. However, empirical evidence shows that liquid alts significantly underperform similar strategy hedge funds, which suggests that traditional hedge funds may be benefiting from an illiquidity premium phenomenon that cannot be easily transported into a mutual fund format.
Investors must understand the various subtleties involved with investing in hedge funds. Although secular bull market trends have arguably made âhedgedâ strategies less critical for inclusion in portfolio allocations than they were during the mid-to-late 2000s, the overall popularity of hedge funds tends to be somewhat cyclical. Notably, as demonstrated by the endowment model of investing, placing hedge funds as a core allocation can increase net returns and reduce risk.
This reading presents the investment characteristics and implementation for the major categories of hedge fund strategies. It also provides a framework for classifying and evaluating these strategies based on their risk profiles. Section 1 summarizes some distinctive regulatory and investment characteristics of hedge funds and discusses ways to classify hedge fund strategies. Sections 2 through 12 present investment characteristics and strategy implementation for each of the following hedge fund strategy categories: equity-related; event-driven; relative value; opportunistic; specialist; and multi-manager strategies. Section 13 introduces a conditional factor model as a unifying framework for understanding and analyzing the risk exposures of these strategies. Section 16 evaluates the contributions of each hedge fund strategy to the return and risk profile of a traditional portfolio of stocks and bonds. The reading concludes with a summary.
Classification of Hedge Funds and Strategies
The most important characteristics of hedge funds are summarized as follows:
Legal/Regulatory Overview: Different countries have varying requirements for investor eligibility to access hedge fund investments. These regulations are typically intended to limit access to traditional hedge funds to sophisticated investors with a minimum income or net-worth requirement, and they allow hedge fund managers to accept only a limited number of investment subscriptions. Most traditional hedge funds in the United States are offered effectively as private placement offerings. Whether the underlying fund manager must register with regulatory authorities depends on assets under management (AUM); however, regardless of AUM, all US hedge funds are subject to regulatory oversight against fraudulent conduct. Hedge funds offered in other jurisdictionsâattractive, tax-neutral locales like the Cayman Islands, the British Virgin Islands, or Bermudaâare typically presented to investors as stand-alone corporate entities subject to the rules and regulations of the particular locality.
From a regulatory perspective, the advent of liquid alts has likely caused the greatest shift in the industry over the past decade. Some of the more liquid hedge fund strategies that meet certain liquidity and diversification requirements (generally long/short equity and managed futures strategies) are offered by many fund sponsors in mutual fund-type structures in the United States and in the undertakings for collective investment in transferable securities (UCITs) format in Europe and Asia. By law, these liquid alts vehicles can be more widely marketed to retail investors. Whereas traditional hedge funds typically offer only limited periodic liquidity, liquid alts funds may be redeemed by investors on a daily basis. Also, traditional hedge funds typically involve both a management fee and an incentive fee; however, liquid alts in most countries are prohibited from charging an incentive fee.
Finally, the overall regulatory constraints for hedge funds are far less than those for regulated investment vehiclesâexcept for the liquid alts versions, which have much higher constraints to provide liquidity to investors.
Flexible MandatesâFew Investment Constraints: Given the relatively low legal and regulatory constraints faced by hedge funds, their mandates are flexible; thus, they are relatively unhindered in their trading and investment activities in terms of investable asset classes and securities, risk exposures, and collateral. The fund prospectus (i.e., offering memorandum) will specify the hedge fundâs mandate and objectives and will include constraints, if any, on investment in certain asset classes as well as in the use of leverage, shorting, and derivatives.
Large Investment Universe: Lower regulatory constraints and flexible mandates give hedge funds access to a wide range of assets outside the normal set of traditional investments. Examples include private securities, non-investment-grade debt, distressed securities, derivatives, and more-esoteric contracts, such as life insurance contracts and even music or film royalties.
Aggressive Investment Styles: Hedge funds may use their typically flexible investment mandates to undertake strategies deemed too risky for traditional investment funds. These strategies may involve significant shorting and/or concentrated positions in domestic and foreign securities that offer exposure to credit, volatility, and liquidity risk premiums.
Relatively Liberal Use of Leverage: Hedge funds generally use leverage more extensively than regulated investment funds. Their leveraged positions are implemented either by borrowing securities from a prime broker or by using implied leverage via derivatives. In many instances, such leverage is necessary to make the return profile of the strategy meaningful. In other instances, derivatives may be used to hedge away unwanted risks (e.g., interest rate or credit risk) that may create high ânotional leverageâ but result in a less risky portfolio. Within long/short equity trading, leverage is most often applied to quantitative approaches in which small statistical valuation aberrationsâtypically over short windows of timeâare identified by a manager or an algorithm. Such quant managers will typically endeavor to be market neutral but will apply high leverage levels to make the opportunities they identify meaningful from a return perspective.
Hedge Fund Liquidity Constraints: Limited partnership-format hedge funds involve initial lock-up periods, liquidity gates, and exit windows. These provide hedge fund managers with a greater ability to take and maintain positions than vehicles that allow investors to withdraw their investment essentially at will. It is thus not surprising that empirical evidence shows that such privately-placed hedge funds significantly outperform similar-strategy liquid alts products by approximately 100 bpsâ200 bps, on average, per year.
Relatively High Fee Structures: Hedge funds have traditionally imposed relatively high investment fees on investors, including both management fees and incentive fees. These have historically been 1% or more of AUM for management fees and 10%â20% of annual returns for incentive fees. The incentive fee structure is meant to align the interests of the hedge fund manager with those of the fundâs investors.
With this background, we now address how hedge funds are classified. One distinction is between single manager hedge funds and multi-manager hedge funds. A single-manager fund is a fund in which one portfolio manager or team of portfolio managers invests in one strategy or style. A multi-manager fund can be of two types. One type is a multi-strategy fund, in which teams of portfolio managers trade and invest in multiple different strategies within the same fund. The second type, a fund-of-hedge funds, often simply called a fund-of-funds (FoF), is a fund in which the fund-of-funds manager allocates capital to separate, underlying hedge funds (e.g., single manager and/or multi-manager funds) that themselves run a range of different strategies.
At the single manager and single strategy level, hedge fund strategies can be classified in various ways. The taxonomy is often based on some combination of:
the instruments in which the managers invest (e.g., equities, commodities, foreign exchange, convertible bonds);
the trading philosophy followed by the managers (e.g., systematic, discretionary); and
the types of risk the managers assume (e.g., directional, event driven, relative value).
Most prominent hedge fund data vendors use a combination of these criteria to classify hedge fund strategies. For example, Hedge Fund Research, Inc. (HFR) reports manager performance statistics on more than 30 strategies and divides funds into six single strategy groupings that are widely used in the hedge fund industry. HFRâs six main single strategy groupings are 1) equity hedge; 2) event driven; 3) fund-of-funds; 4) macro; 5) relative value; and 6) risk parity.
Lipper TASS, another well-known data vendor, classifies funds into the following ten categories: 1) dedicated short bias; 2) equity market neutral; 3) long/short equity hedge; 4) event driven; 5) convertible arbitrage; 6) fixed-income arbitrage; 7) global macro; 8) managed futures; 9) fund-of-funds; and 10) multi-strategy.
Morningstar CISDM goes even further and separates hedge funds in its database into finer categories, like merger arbitrage and systematic futures, among others. In addition, the Morningstar CISDM Database separates fund-of-funds strategies into several different sub-categories, such as debt, equity, event driven, macro/systematic, multi-strategy, and relative value.
Eurekahedge, an important index provider with its roots in Asia, has grown to include many smaller hedge fund managers globally. Its main strategy indexes include nine categories: 1) arbitrage; 2) commodity trading adviser (CTA)/managed futures; 3) distressed debt; 4) event driven; 5) fixed income; 6) long/short equities; 7) macro; 8) multi-strategy; and 9) relative value.
A final example of a prominent hedge fund data vendor is Credit Suisse. Its Credit Suisse Hedge Fund Index is an asset-weighted index that monitors approximately 9,000 funds and consists of funds with a minimum of US$50 million AUM, a 12-month track record, and audited financial statements. The index is calculated and rebalanced monthly, and it reflects performance net of all performance fees and expenses. Credit Suisse also subdivides managers into nine main sub-indexes for strategy areas: 1) convertible arbitrage; 2) emerging markets; 3) equity market neutral; 4) event driven; 5) fixed income; 6) global macro; 7) long/short equity; 8) managed futures; and 9) multi-strategy.
These different data providers use different methodologies for index calculation. HFR produces both the HFRX Index of equally weighted hedge funds, which includes those that are open or closed to new investment, and its HFRI index series, which tracks only hedge funds open to new investment. Because managers who have closed their funds to new investment are typically superior managers who are limited in their capacity to manage additional funds, the HFRX series regularly outperforms the HFRI series. However, the mix of managers represented by the HFRX Index would obviously not be replicable in real-time by an investor, thus limiting its usefulness. Meanwhile, the Credit Suisse Hedge Fund Index is weighted by fund size (i.e., AUM), so its overall performance is more reflective of the performance of the larger hedge funds, such as the multi-strategy managers.
Notably, less overlap exists in manager reporting to the different index providers than one might expect or is likely optimal. In fact, less than 1% of hedge fund managers self-report to all the index service providers mentioned. Clearly, no single index is all-encompassing.
Generally consistent with the above data vendor groupings and with a practice-based risk factor perspective, this reading groups single hedge fund strategies into the following six categories: 1) equity; 2) event-driven; 3) relative value; 4) opportunistic; 5) specialist; and 6) multi-manager.
Equity-related hedge fund strategies focus primarily on the equity markets, and the majority of their risk profiles involve equity-oriented risk. Within this equity-related bucket, long/short equity, dedicated short bias, and equity market neutral are the main strategies that will be discussed further.
Event-driven hedge fund strategies focus on corporate events, such as governance events, mergers and acquisitions, bankruptcy, and other key events for corporations. The primary risk for these strategies is event risk, the possibility that an unexpected event will negatively affect a company or security. Unexpected events include unforeseen corporate reorganization, a failed merger, credit rating downgrades, or company bankruptcy. The most common event-driven hedge fund strategies, merger arbitrage and distressed securities, will be discussed in detail.
Relative value hedge fund strategies focus on the relative valuation between two or more securities. These strategies are often exposed to credit and liquidity risks because the valuation differences from which these strategies seek to benefit often are due to differences in credit quality and/or liquidity across different securities. The two common relative value hedge fund strategies to be covered further are fixed-income arbitrage and convertible bond arbitrage.
Opportunistic hedge fund strategies take a top-down approach, focusing on a multi-asset (often macro-oriented) opportunity set. The risks for opportunistic hedge fund strategies depend on the opportunity set involved and can vary across time and asset classes. The two common opportunistic hedge fund strategies that are discussed in further detail are global macro and managed futures.
Specialist hedge fund strategies focus on special or niche opportunities that often require a specialized skill or knowledge of a specific market. These strategies can be exposed to unique risks that stem from particular market sectors, niche securities, and/or esoteric instruments. We will explore two specialist strategies in further detail: volatility strategies involving options and reinsurance strategies.
Multi-manager hedge fund strategies focus on building a portfolio of diversified hedge fund strategies. Managers in this strategy bucket use their skills to combine diverse strategies and dynamically re-allocate among them over time. The two most common types of multi-manager hedge funds are multi-strategy funds and fund-of-funds, which we will discuss in further detail.
Exhibit 1:
Hedge Fund Strategies by Category
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