Hedge Funds: Relative Value and Opportunistic Strategies

Hedge funds that pursue __relative value strategies__ are seeking an opportunity to profit from price discrepancies. For example, suppose Fitness Drink Co. is thought to be overvalued while Sports Drink Co. is thought to be undervalued. If a manager could take both long and short positions, how do you think the manager could take advantage of these expectations?

Not quite. A long position in an overvalued company isn't a good idea.

Absolutely. Buy the undervalued company, and sell short the overvalued company. If the manager is right, there will be a profit from both positions.

Relative value strategies typically involve buying one security and selling another simultaneously like this, based on some price abnormality that should revert back to normal with time. There are five types used often.

The first is called __fixed income convertible arbitrage__. A _convertible bond_ starts as a regular fixed payment bond and has the option to be converted to the underlying stock. Suppose an investor bought a $100 convertible bond that pays 5% interest and has an option to convert to Sports Drink Co. (SDC) at a $20 strike price. What do you think an investor would do if SDC was trading at $10?

No. It is not a good idea to convert before the strike price, because the investor will give up income from the coupon payment.

Correct. The investor would hold the bond and continue to accept coupon payments until the stock possibly trades higher in the future. The downside of this is that the coupons are usually much lower than those of a conventional bond due to the embedded stock option. It can be difficult to trade out of the bond as well, because it usually loses value the farther away it trades from the strike price.

No. Locking in a loss defeats the purpose of an equity option.

In case the price of SDC falls, a hedge fund would want to sell SDC short using the convertible arbitrage strategy. In this case, Awesome Assets would buy the convertible bond while simultaneously selling SDC short at $20. This way, it can still profit if the stock price declines. For example, if SDC trades at $10, the investor can convert and buy SDC at $10 and sell at $20 (the price of the short), creating a $10 per share profit.

The __fixed income general__ strategies are trades based on mispricings of any two securities in the bond markets, whether it is government-, corporate-, or yield-related. Another strategy related to bonds is __fixed income asset backed__. This is simply a relative value trade that seeks to profit from a mispricing of a bond that is backed by assets, collateral, or mortgages. Suppose a premium 10-year treasury bond has a yield of 4% and a discounted two-year is trading at 4%. Awesome Assets recognizes the flat curve as a distortion, so it shorts the 10-year and buys the two-year. What type of relative value strategy do you think this is?

No. Collateral does not back treasuries.

No. A convertible bond is not involved in this trade.

Correct. Trades on the yield curve are a fixed income general strategy. __Volatility__ strategies can profit on the volatility in the market as a whole or an asset class by going long or short on related options. Finally, __multi-strategy__ looks for opportunities anywhere they might exist.

Macro hedge funds use __macro strategies__, which are similar to relative value in a way. Macro strategies address the movement and possibilities of a fund across the global market and look to profit from the overarching conditions. Investments will involve a large portion of a portfolio and are based primarily on forecasts. Funds are betting on the potential fluctuation of currency, commodities, stock, and equity in most cases. Finally, managed futures funds are also known as __commodity trading advisers (CTAs)__ that model and measure trends and momentum. This has offered diversification benefits in the past, but mean-reverting markets and CTA movements toward stock and bond index futures have reduced these diversification benefits.

To summarize: [[summary]]

No. Consider both a long and short position that would be better in combination.

Long Fitness Drink and short Sports Drink

Short Fitness Drink and long Sports Drink

Short Fitness Drink and short Sports Drink

Convert to stock and hope that the stock price goes up over time

Do nothing and accept coupon payments from the bond

Convert to stock at a $20 strike price and immediately sell it for $10, taking a $10 loss on the investment

Fixed income asset backed

Fixed income convertible arbitrage

Fixed income general

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