Hedge Fund Strategies to generate positive Alpha
Let’s review some of the most interesting Hedge Fund Strategies used to generate positive Alpha.
Statistical Arbitrage – Hedge Fund Strategy
Statistical Arbitrage, or StatArb, is a heavily quantitative and computational approach to equity trading. It describes a variety of automated trading systems that commonly make use of data mining, statistical methods, and artificial intelligence techniques. A popular strategy is pairs trade, in which stocks are put into pairs by fundamental or market-based similarities. One stock in the pair is bought long, the other is sold short. This hedges risk from whole-market movements.
Victor Niederhoffer and David Shaw are amongst the founders of this approach. However, in recent years, there has been a trend away from simple pair-trading, and now it is much more common for
portfolios of stocks to be ‘clustered’ by sector and region in offsetting any beta exposure. Stat Arb is actually any strategy that is bottom-up, beta-neutral in approach, and uses statistical/econometric techniques in order to provide signals for execution. Signals are often generated through a contrarian mean-reversion principle, but can also be formed by extreme psychological barriers, corporate activity, as well as short-term momentum.
Statistical arbitrage has become a major force at both hedge funds and investment banks. Many bank proprietary operations now center to varying degrees around statistical arbitrage trading. Some of the leading statistical arbitrage hedge funds are Renaissance Technologies, D.E. Shaw, and Citadel Investment Group. In the bank space, some of the leading stat arb desks include Goldman Sachs (global), Deutsche Bank (London), TD Securities (Chicago), and Morgan Stanley (New York).
Equity market neutral – Hedge Fund Strategy
Equity market neutral strategies, associated with hedge fund investing, seek to exploit factors unique to the particular stock by staying neutral on factors that reflect broader conditions in the sector, industry, level of market capitalization, country, or region.
The strategy achieves its end by with a Long/short equity position within a single sector or asset class. By hedging a long position in a single sector-specific stock with a short position in the same sector, for instance, the equity market neutral investor will not be affected by sector-wide volatility. It is, in essence, a bet that one security will outperform another security, regardless of the strength of its sector or asset class.
This was the strategy of the paradigmatic hedge fund run by Alfred Winslow Jones between 1949 and 1966.
Jones and his equity market neutral strategy was profiled in an article in Fortune magazine, 1966, by Carol Loomis, The Jones nobody keeps up with. He had managed to keep his methods out of the public eye until that point.
Long/short equity is an investment strategy, generally associated with hedge funds, which earns return from the stock-picking, and isolates the risk (as well as the return) of a particular stock from the risk/return of the broader market or the industry of which it is a part.
For example, a long/short fund manager might sell short one automobile industry stock, while buying (taking a long position) on another — short of DaimlerChrysler, long on Ford. Thereafter, any general development that improves the yield of auto industry stocks, in general, will help this fund’s Ford position but will hurt its DaimlerChrysler position.
Likewise, any general development that worsens the yield of auto industry stocks, in general, will hurt the Ford position but will help its DaimlerChrysler position. The two positions are offsetting, so the portfolio is hedged against developments that affect the auto industry in general.
This isn’t the same as a true equity market neutral strategy, which may be regarded as just the limiting case of long/short.
Fixed Income arbitrage
Fixed Income arbitrage is an investment strategy generally associated with hedge funds, which consists of the discovery and exploitation of inefficiencies in the pricing of bonds, i.e. instruments from either public or private issuers yielding a contractually fixed stream of income.
Most arbitrageurs who employ this strategy trade globally.
In pursuit of their goal of both steady returns and low volatility, the arbitrageurs can focus upon interest rate swaps, US non-US government bond arbitrage, see US Treasury security, forward yield curves, and/or mortgage-backed securities.
The practice of fixed-income arbitrage, in general, has been compared to that of running in front of a steam roller to pick up nickels lying on the street . Some arbitrageurs end up flattened. See Long-Term Capital Management.
Convertible arbitrage is a market-neutral investment strategy often associated with hedge funds. It involves the simultaneous purchase of convertible securities and the short sale of the same issuer’s common stock.
The premise of the strategy is that the convertible is sometimes priced inefficiently relative to the underlying stock, for reasons that range from illiquidity to market psychology.
The number of shares sold short usually reflects a delta neutral or market neutral ratio. As a result, under normal market conditions, the arbitrageur expects the combined position to be insensitive to fluctuations in the price of the underlying stock. However, maintaining a market neutral position may require rebalancing transactions, a process called dynamic delta hedging.
As with most successful arbitrage strategies, convertible arbitrage has attracted a large number of market participants, creating intense competition and reducing the effectiveness of the strategy. For example, many convertible arbitrageurs suffered losses in early 2005 when the credit of General Motors was downgraded at the same time Kirk Kerkorian was making an offer for GM´s stock. Since most arbitrageurs were long GM debt and short the equity, they were hurt on both sides.
Going back a lot further, many such “arbs” sustained big losses in the so-called “crash of ’87”. In theory, when a stock declines, the associated convertible bond will decline less, because it is protected by its value as a fixed-income instrument: it pays interest periodically (while the stock may only pay a dividend, which can be suspended in bad times).
In the 1987 stock market crash, however, many convertible bonds declined more than the stocks into which they were convertible, apparently for liquidity reasons (the market for the stocks being much more liquid than the relatively small market for the bonds). Arbitrageurs who relied on the traditional relationship between stock and bond gained less from their short stock positions than they lost on their long bond positions.
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