Chris Jones, Head of Alternatives at bfinance, dissects the different main hedge funds strategies to find out what really drives returns, what are the hidden risks and are any of these strategies really good as portfolio diversifiers?

Because the term hedge fund is a broad one, investors need to target risk budget and the particular types of hedge funds that will suit their objectives rather than just investing in hedge funds per se. Hedge funds are notoriously difficult to define. It is an umbrella term that covers quite a wide range of strategies, of risks, of mark exposures. It is often referred to as an asset class, which it just isn’t. There is no underlying asset but more a disparate collection of active trading strategies that drives returns. One thing that hedge funds do share is an absolute return objective and the aim to make money whatever the underlying markets, through wider mandates and use of non-conventional investment techniques like selling short, use of derivatives, etc.

Hedge fund strategies vary radically in terms of market exposure and risk. And contrary to a common belief, it is not true to say that a hedge fund investment is a good way to achieve portfolio diversification. Investors get expensive access to a different return stream and maybe a skill generated return stream, but not necessarily a diversifying return stream. Basically, the hedge fund universe can be split pretty exhaustively in four main areas: equity long/short, relative value, event driven and trading.

Equity Long/Short

Equity Long/Short is essentially the direct analog to the traditional equity investment. The manager finds undervalued equities to buy and overvalued equities to short. This is often a first step investment for those who invest directly in hedge funds, because this strategy is one of the more simple to understand. The rationale for returns is just the same as active management in the traditional equity world: stocks are not always at fair value, but also important to equity long/short is the ability to vary exposure and take short positions as well. Given that equity markets tend to be reasonably efficient over the long run, especially in larger cap areas, a large amount of returns is due to manager skill. There is not a lot of inherent return from the strategy, no static yield.

The drives of return, as well as skill, are market direction. There is a vast amount of beta in equity long/short, even in equity market neutral which is meant to be beta free. Indeed, in a time of equity market crash or crisis, betas go all over the place and, as a result, a market neutral portfolio has quite a bit of equity market exposure. How market neutral strategies have behaved during various market crashes evidence this. Also, there is more than just management skill in the drivers of return of long/short strategies. There are less obvious factors as well, like value versus growth, mid versus large cap and so forth. Periods of market noise or intra-market correlations, followed by a snap to fundamentals is another more subtle driving factor.

However, the good thing is Long /Short strategies are pretty transparent. The major risks are obvious, unlike some other hedge fund strategies where there are deeply imbedded risks that aren’t displayed for the volatility of returns, or in an obvious way. On major risks, people often look at shorting as the opposite of being long. That is not the case. If you own a stock, the most you can lose is the value of that stock, if you’re short a stock, you can lose, in theory, infinity because it can go up twice, ten times or whatever. If you short a rubbish little stock, of very little value and it becomes all of a sudden a massive takeover candidate, then that stock could go up quite considerately and you have this problem whereby you can lose a lot more money on the short side.

Finally, because of their beta exposure, Long /Short is not an effective portfolio diversifier strategy. Having said that, because it’s quite a simple strategy by comparison to others, there’s quite a low level of hidden risk.

Event driven

Event driven strategies aim to generate returns from market inefficiencies surrounding corporate events, such as mergers or defaults. So the returns existing here are really due to event driven specialists having a niche skill set (knowledge of the complexity surrounding corporate events, such as mergers and acquisitions, or such as a company defaulting on its coupon, a company’s debt becoming distressed and so forth).

Returns, for example, are driven by the deal premium, the deal flow in mergers, by the default rate, the discount to fair value in distressed debt. There is also a return coming from liquidity premium or, to be more precise, illiquidity premium. A lot of distressed debt is semi liquid and can quickly become illiquid in the sense that the hedge fund manager doesn’t want to sell at a completely decorelated price.

If getting a direct yield from complexity and market inefficiency can look like, in good times, quite a diversifying strategy, in bad times it can become quite correlated with equity and credit exposures. This issue is never going to fade. A market crash or a big sell-off in equity or a big winding of credit spreads will affect the event-driven book and there is very little that can be done to isolate that book from market crashes, or illiquidity problems.

As a result, although there’s a good measurable level of inherent return in event driven strategies, they don’t qualify as effective diversifiers due to the inefficiencies and hidden risks that drive performances.  This doesn’t mean that it is a bad strategy, and none of the hedge fund strategies are bad, but for an investor presumably targeting diversification, this is not the first port of call.

Relative value

Relative value aims to generate returns from spreads or pricing discrepancies between similar instruments in markets, like short term inefficiencies generated from supply/demand mismatches. As an example, when a big buyer wants to buy debt of a certain maturity, his demand creates a little kink in the yield curve which can be exploitable. This is sometimes referred to as “arbitrage”, an instantaneous, risk-free profit from markets. It doesn’t really exist anymore, or only exists in the way that we have to be so leveraged to get a return worth anything, that it’s impractical. However, this strategy is not instantaneous, nor risk-free, even if it is often viewed as market independent and lower risk.

Longer term structural inefficiencies in markets exist, like maybe the inherent price of credit in a bond compared to a credit default swap. Credit analysts, equity analysts and risk management officers don’t especially share the same view on a company valuation and this can generate inefficiencies. Also, market volatility can make market instruments diverge.

Major risks are related to those of equity investing, credit investing, hedge funds, infrastructure... There are deep pockets risks as a trade can go against you and investors pull the money before things converge again. There is counterparty risk as lots of transactions are done over the counter. There are all sorts of new areas such as CVA trading and so forth that tries to make a market, but if you buy a load of insurance against Armageddon, if there is Armageddon, the people who are the counterparties to your insurance are going to be as dead as everybody else. There’s illiquidity risk as well.

Relative value strategies seek a higher level of inherent return. There’s good effective diversification here as the returns don’t generally look linked to the underlying markets. However, there is lots of hidden risk.

Trading

Trading strategies regroup everything from quantitative investing, trend following and trading. The rationale for returns is manager skill, particularly in the more discretionary tactical trading and global macro area, along with technological advantage, in presence of a quantitative trading system.

How can trend following from various futures markets make money? Speculators reap a premium from the hedges in the futures markets, which are ever present in FX or in commodity markets. A global macro fund manager has a whole 'push and pull' between bottom up from fundamentals and top down macro situations, which causes prices to oscillate. Concerning the global macro space, the strategy is very much skill driven.

Overall, for managed futures CTA quantitative traders returns are driven by market volatility and trending behaviour in markets. Being trend following relates to implicitly long volatility in the sense that if the market moves down, the quantitative strategy implies to short and make money, quantitatively, and if the market goes up, the strategy implies to be long quantitatively.

Although tactical trading, CTA’s and so forth are a good diversifying strategy; there’s nothing to say that  CTAs, managed futures and quantitative trading are never on the wrong side of equity markets when they crash.

The major risks here, particularly on the global macro side, but also on the CTA side, is “what if it stops making money?” When CTAs or macros have times of underperformance, it’s difficult to work out why things aren’t working. It remains difficult to describe the level of inherent return. The good thing is that there are few hidden risk. Trading is a pretty explicit strategy.

HEDGE FUNDS STRATEGIES DISSECTED

Overall hedge fund strategies present pros and cons just like any other area of investment. I have tried to be honest about both benefits and risks and so the above may sound a little negative. However, even when risks are considered, some hedge fund strategies can act as particularly good diversifiers and other hedge fund strategies, although less diversifying, can also add an enhancing return stream to the wider portfolio.

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