HEDGE FUND STRATEGIES

2014-10-13

As previously discussed, hedge funds employ many different strategies. It is important to remember that no hedge fund strategy is standard—each portfolio manager will have his or her own unique style of investing.

Hedge fund strategies can be built from a number of different elements:

  • Style:Global Macro, Directional, Event-Drive, Arbitrage
  • Market: Equity, Fixed Income, Commodities, Foreign Exchange
  • Instrument:Long/Short Equity, Futures, Options, Swaps
  • Exposure:Directional, Market Neutral
  • Sector: Healthcare, Industrials, Consumer, Energy, Real Estate, Financials, Tech, etc.
  • Diversification:Multi-Manager, Multi-Strategy, Multi-Fund, Multi-Market

HEDGE FUND STYLES

Global Macro Style: Try to anticipate and capitalize on global macroeconomic events; this is usually considered a “top-down approach” to investing.

  • Discretionary Macro:The strategy is carried out by investment managers selecting investments.
  • Systematic Macro: The strategy is carried out using mathematical models and software.
  • Multi-Strategy: The hedge fund uses a combination of strategies.
Directional Style: Hedge investments with exposure to the equity market.

  • Long/Short Equity:Takes long equity positions while short-selling other equities or indices
  • Emerging Market: Specializes in emerging markets such as China, Brazil, India, etc
  • Sector Funds:Specializes in niche areas such as Healthcare, Industrials, or Consumer
  • Fundamental Growth:Invests in companies with more earnings growth than the broader market
  • Fundamental Value:Invests in companies that are considered undervalued
  • Multi-Strategy: Uses a combination of strategies

Event-Driven Style (also called Special Situations): The fund profits from price inefficiencies caused by anticipated specific corporate events, such as bankruptcy, reorganization, divestitures, and legal situations.

Distressed Debt: Specializes in companies trading at discounts because of bankruptcy or the threat thereof.

Merger Arbitrage (also called Risk Arb): Profits from price inefficiencies relating to companies involved in announced Mergers & Acquisitions activity; a typical position might involve buying the equity of an acquisition target, and hedging the investment by shorting an appropriate amount of the equity in the acquirer.

Credit Arbitrage: Profits from relative value investments in corporate fixed income securities, such as purchasing the unsecured debt of a corporation while selling short the secured debt of the same corporation.

Activist: Takes large positions in companies and uses this ownership stake to influence the decision making of management in the companies.

Legal Catalysts: Profits from position taking with companies involved in major lawsuits.

Arbitrage Style (also called Relative Value): Profits from perceived price inefficiencies between related securities. (Note that the finance term “arbitrage” strictly means a riskless profit – seldom found in actual traded securities markets. However, the term is used to also describe investment opportunities that have a relatively high probability of profit with relatively low downside.)

  • Fixed Income Arbitrage:Profits from price inefficiencies between fixed income securities
  • Equity Arbitrage: Profits from price inefficiencies between equity securities (keeping a close balance between long and short positions)
  • Convertible Arbitrage:Profits from price inefficiencies between convertible securities and their corresponding stocks
  • Others:Statistical Arbitrage, Volatility Arbitrage, Regulatory Arbitrage

BACKGROUND OF MULTI-MANAGER VS. SINGLE P&L MODEL

When going through hedge fund interviews, it is important to distinguish between a multi-manager hedge fund model vs. a single P&L hedge fund model. A multi-manager hedge fund consists of multiple specialized hedge funds. Each specialized fund has its own P&L in which it is allowed to invest across different sectors and markets. The theory is founded on a premise that not all investment managers are good in all markets and not all managers are successful at all times. Spreading the investment across different Portfolio Managers allows the fund to achieve diversifications and reduce risk. A single P&L hedge fund model is a typical hedge fund; the fund has one P&L and a fixed number of Portfolio Managers.

MULTI-MANAGER FUNDS

Multi-manager hedge funds were popularized by Steven A. Cohen at SAC Capital. Cohen employs anywhere from 70-90 portfolio managers, each of whom have a designated AUM to manage. Other popular multi-manager hedge funds include:

  • Millennium Partners
  • Surveyor Capital (part of Citadel)
  • Visium Asset Management

ADVANTAGES & DISADVANTAGES OF MULTI-MANAGER FUNDS

ADVANTAGES FROM THE PERSPECTIVE OF A PORTFOLIO MANAGER

  • Autonomy: Manager has the ability to run his own discretionary set of positions (known as a “book”), with reduced stress from a potentially overbearing hedge fund owner.
  • Cost efficiency: Infrastructure is largely paid for by the employer, not the employee (sub-manager), and the platforms generally provide back-office support and often trading support.
  • Potentially portable track record: Manager can often take performance track record to other funds or spin off own hedge fund.
  • Large percentage of the profit: Payouts can be as high as 20% of profits at some funds.

DISADVANTAGES FROM THE PERSPECTIVE OF A PORTFOLIO MANAGER

  • AUM/capital can get reduced without notice or cause.
  • Manager typically does not have the autonomy to raise capital independent from the fund, so the manager is limited to the capital allocator’s discretion.
  • The manager often has tighter risk controls than if the manager were independent:
    • Total volatility of the portfolio has to be under certain volatility limits.
    • Weighted average volatility of the longs has to be within a certain percentage of the weighted average volatility of the short.
  • Potentially tenuous job security: A portfolio manager can make money for a number of years and have one down year and get fired as a result.

ADVANTAGES FROM THE PERSPECTIVE OF AN ANALYST

  • Analyst can get a fixed payout, typically 5-20% of profit depending on the level of seniority.
  • Analyst has the potential to get the right to manage his own book (become a portfolio manager).
  • Analyst has the ability to be exposed to multiple investment styles at the fund.

DISADVANTAGES FROM THE PERSPECTIVE OF AN ANALYST

  • Very high-pressure environment: analysts often compete directly with each other.
  • An analyst’s primary goal is to become a better investor, but some multi-managers are so focused on the short term that analysts become fast-money investors.
  • Potentially higher turnover: Portfolio Managers can often fire analysts in a shorter period of time at a multi-manager fund, as they often have a tremendous amount of pressure to perform quickly.

SINGLE P&L FUNDS

Arguably the most popular single P&L model was formed by Julian Robertson through Tiger Management, one of the earliest hedge funds. Many of the analysts and managers that Robertson employed at Tiger Management went out on their own and are now running some of the best-known hedge funds, called “Tiger Cubs.” Popular tiger cubs include:

  • Blue Ridge Capital
  • Shumway Capital Partners
  • Lone Pine Capital LLC
  • Tiger Asia Management LLC
  • Touradji Capital Management LP
  • Viking Global Investors LP
  • Maverick Capital Ltd

ADVANTAGES & DISADVANTAGES OF SINGLE P&L FUNDS

ADVANTAGES

  • Position involves heavy exposure of investment professionals to the senior investors.
  • The fund has less dependency on short-term performance, so it is often a less stressful environment.
  • They typically adhere to a structured, top-down investment philosophy.

DISADVANTAGES

  • It is rare for an investment professional to get his own book to manage.
  • Payout is often discretionary, and in periods of strong performance, the partners are sometimes not as generous as one might think they should be.
  • It involves a limited exposure to other investment styles.
  • Sometimes the short-term performance at these funds can suffer because of entrenched investment philosophies. For example, many Tiger Cubs take a buy and hold approach that has not worked over the past few years–Tiger Cubs typically short “bad” companies, but bad companies are typically very high beta companies, and this class of equities has been the biggest outperformer during that time.
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