In the first article on hedge fund strategies, we studied directional hedge fund strategies namely long only and short only and long-short strategy. In part two of the series, we will study some market neutral and arbitrage strategies used by hedge fund managers.
Market neutral strategy
While market neutral strategy is similar to long-short strategy i.e. it seeks to minimize market risk there is a key difference between the two. While long-short funds can have a net long bias or net short bias depending on the fund manager’s view, market neutral funds try to achieve a portfolio beta (β) as close to zero as possible to protect against market risk. For instance, if a fund manager buys a security having β of 1, he will counter it by buying another security having -1 β to maintain zero β in the portfolio.
While possible theoretically, in reality, it is extremely difficult to construct a portfolio with a beta of zero. Overall, it is a low risk low return strategy compared to long-short funds.
Market risk is risk inherent to entire market. It is also called as systematic risk.
Beta (β) is a measure of the movement in the portfolio in response to overall market movement. So a beta of ‘zero’ means that the portfolio will have zero correlation with market movements.
The two common types of market neutral strategies are:
Statistical Arbitrage
Fundamental Arbitrage
Statistical arbitrage
These funds analyse historical price movement in equities to identify pricing mismatches. Using this data, the fund managers will invest in stocks whose prices are expected to revert to mean over a period of time.
Fundamental arbitrage
Under fundamental arbitrage, the fund manager uses fundamental analysis to shortlist stocks whose price will revert to mean over time.
Arbitrage strategies
Convertible arbitrage
Before talking about convertible arbitrage, let us first understand convertible bonds. These bonds give investor an option to convert bonds into to stock of the company at a price which tends to be lower than the market price of the stock (at the time of the issue).
Fund managers follow this strategy to go long on convertible bonds and short on equity stock of the company. The idea is that if the stock price declines, the fund manager gains through short sale of stocks. Moreover, it is likely that convertible bonds will see a lower drop in price compared to their stocks as they are considered to be part of fixed income instruments. On the other hand, if stock price rises, the fund manager can convert the bonds to equity shares of the company and sell them at a higher price to limit losses.
However, if the convertible bond is overpriced vis-à-vis the stock then the fund manager will take a short position in the convertible bond and a long position in the underlying stock.
Fixed income arbitrage
Fixed income arbitrage strategy tries to profit from pricing differences in fixed income securities by taking opposing positions in mispriced bonds or their derivatives. The expectation is that their prices will revert to mean over time. Common fixed income arbitrage strategies include swap-spread arbitrage (fund managers take a bet on direction of credit default swap rates and other bank interest rates), yield curve arbitrage (fund managers seek to profit from shifts in the yield curve) and capital structure arbitrage (fund managers try to exploit pricing inefficiency in the company’s capital structure that is stock price v/s bond valuation). This is a very high risk strategy as they tend to use a significant amount of leverage.