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Hedge Funds are the privately-owned companies which pool the investors’ money and reinvest them into complicated financial instruments to outperform the market. These are often set up as limited partnerships owing to its higher volatility and risks inherent in the managed portfolios. Hedge fund manager is paid performance-based incentives in addition to the management fees in order to align the interest of the shareholders and fund managers. Since these funds are complicated and come with higher risks, these are suitable for wealthier investors who can pay higher fees and can bear risks associated with hedge fund investing. These have the potential to offer more returns to compensate for the risk undertaken and attract investors on the basis of the track record of performance of portfolios. Not to forget, hedge funds are not as scrupulously regulated like mutual funds and the stock markets and thus are able to borrow funds and create leverage for executing more complex and speculative strategies. Also, hedge funds are illiquid investments and may not be redeemable at the investor’s option.
Classification of Hedge Fund Strategies: Hedge Fund Strategies can be classified into various categories, some of which are mentioned below.
- Equity-oriented: These strategies focus on equity markets and are subject to equity-related risks. Some strategies under this category include Long/Short Equity, Dedicated Short Bias and Equity Market Neutral.
- Event Driven: These strategies focus on corporate events such as mergers and acquisitions, restructuring, bankruptcy, etc. One significant risk under this strategy is the non-occurrence of the event. Strategies include merger arbitrage and distressed securities.
- Relative Value Strategies: These strategies are focused on the relative valuation of two or more securities and are often carry inherent credit and liquidity risks. This includes strategies like Fixed Income Arbitrage and Convertible Bond Arbitrage.
- Opportunistic Strategies: These involve a top-down approach and focus on multi-asset opportunity sets. These include global macro strategies and managed futures.
Apart from these, hedge fund strategies also include specialist strategies and multi-manager strategies. Let us now at these strategies in detail.
Long/Short Equity Strategy: Under this strategy, the emphasis is placed on fundamental research, and the hedge fund managers buy equity which is expected to rise and sell the ones which are expected to fall. The intent for the short position is generally to hedge and not to seek alpha. These strategies usually have a net long exposure. Hedge fund managers take concentrated positions, and this constitutes one of the most prevalent strategies, which accounts for 30% of hedge fund strategies. Exposures under this strategy are different for each manager based on his competency and skills. Under this strategy, leverage can be used to multiply returns depending on the certainty of the bets and this squarely depends on the judgement and skills of the fund manager.
Dedicated Short Bias: Under this strategy, short positions are taken and may hold cash to reduce the exposure. Long bets on the market are heavily concentrated, and most institutions are mandated to take long positions. Therefore, the ability to outperform from the short positions is much larger. However, it comes with a lot more risk. Stock selection is the critical skill requirement of the fund manager. These strategies have natural high volatility, and hence, leverage under these strategies are very low.
Market Neutral Strategy: Under the market neutral strategy, both long and short positions are assumed in such a way that the systematic risk of the portfolio is zero. The investment in the long and short positions are equal. Returns are generated by the movement in prices between the long and short positions. Since the risk taken under this strategy is less, leverage taken is higher to magnify the returns.
The second part of the strategies focus on event driven ones -Merger Arbitrage and Distressed Securities
Merger Arbitrage: Under the merger arbitrage strategy, the HF manager bet on events such as merger and acquisitions, and thus, the manager is not really concerned with the GDP, economic conditions etc. The return profile of merger arbitrage comes with a risk of non-occurrence of the event. If the event happens, the manager earns, say 5-7% of the returns, but if the event doesn’t happen, the manager accumulates huge losses. Under this strategy, leverage taken is higher to magnify the returns because hedge fund managers are not content with such small gains and they get paid only when they give higher returns.
Distressed Security Arbitrage: Under this strategy, the company is in distress and is on the verge of bankruptcy and the focus is on the chances of turnaround in the company and whether it will happen or not. The intent of hedge fund managers is entirely to realize financial gains and hence the investment horizon is generally shorter. The nature of distressed securities is highly illiquid because a lot of people have exited the market and a lot of funds are not allowed to invest in distressed securities. Therefore, the number of people chasing these securities is minimal, and hence, the likelihood of generating an alpha is significant.
The other form of strategy is relative value strategy which include Fixed Income Arbitrage and Convertible Bond Arbitrage.
Convertible Bond Arbitrage: Convertible bond is a security which can be converted into equity and have features of both equity and a bond. Any mispricing in similar open market bond and equity can result in arbitrage opportunity and can help HF manager earn free money. This strategy is very complex and hence it is sparsely traded. Since the arbitrage opportunities are very less, HF managers take a high amount of leverage to magnify the returns.
Fixed Income Arbitrage: This strategy tends to exploit market inefficiencies across a wide range of debt securities. Most common strategies include yield curve trades and carry trades. The pay off is very similar to merger arbitrage, which says if you gain, you gain a less amount, but if you lose, you tend to lose a lot more. Since the mispricing opportunities are very less, HF managers take a high amount of leverage to increase the returns.
Let us now look at an asset management company:
Macquarie Group Limited (ASX: MQG)
Macquarie Bank Capital Notes 2 Offer Opens: Macquarie Group Limited (ASX: MQG) is a non-operating holding company with subsidiary companies with competence in the provision of financial services like banking, financial advisory, investment and funds management services. As on 27 February 2020, the market capitalization of the company stood at $50.07 billion. The company has recently announced that it has commenced the offer of Macquarie Bank Capital Notes 2. The size of the offer has been set at $500 million with a margin of 2.90% per annum. MQG will close this offer on 18 March 2020.
The company is focused on delivering exceptional client experiences and has reported healthy regulatory ratios. During 3QFY20, CET1 ratio of the company stood at 14.2%, and the leverage ratio was 5.9%. The company also took on record that S&P Global Ratings has upgraded its long-term issuer credit ratings, reflecting that the bank’s risk management capabilities have strengthened over time.
Regularity Ratios (Source: Company Reports)
Stock Performance: As per ASX, the stock closed at $139.420, down by 1.324% on 27 February 2020. The stock of MQG gave a return of 15.75% in the past six months and a return of 3.66% in the past three months. In terms of valuation, it is trading at a P/E multiple of 15.270x and is earning a dividend yield of 4.32%.
