Describe in detail a major hedge fund trading strategy
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Describe in detail a major hedge fund trading strategy
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HEDGE FUND TRADING STRATEGY : LONG –SHORT EQUITY STRATEGIES
TABLE OF CONTENTS:
S.NO.
PARTICULARS
PAGE NO.
1
WHAT IS A HEDGE FUND? – AN INTRODUCTION
2
2
GROWTH OF HEDGE FUND INDUSTRY
2
3
WHAT IS LONG SHORT EQUITY HEDGE STRATEGY
3
4
GENERATION OF RETURNS & COSTS INVOLVED
8
5
RISKS INVOLVED
9
6
MEASURING RISK
10
7
PERFORMANCE MEASUREMENT
11
8
CONCLUSION
12
9
REFERENCES
13
. WHAT IS A HEDGE FUND? – AN INTRODUCTION
To “hedge” means to take on an asset position such that it lowers overall risk to offset an existing source of risk (Connor et al, 2003).
A hedge fund can be explained to be a private partnership which invests in heterogeneous investments with an aim to maximise expected returns while reducing risk (Kourbetis, 2010). They are speculative investment vehicles which are designed to utilize the high-quality information that is possessed by their managers. It is also generally defined to be an “actively managed, pooled investment vehicle” which is open to only a limited set of investors and that which generates absolute kind of returns. (Connor et al, 2003).
. GROWTH OF HEDGE FUND INDUSTRY
2013 was a year of strong return of investor confidence in the hedge funds industry. The Prequin Report (2014) reports that the most established country in the hedge fund industry is the USA followed by UK. 60% of the fund managers of the world are located in USA and approaximately 21% of the managers are in the U.K. Hedge fund assets have grown more than $ 360 Billion over the year taking the total assets number past the $ 2.6 Trillion mark (Prequin Report, 2014). Assets Under Management (AUM) of UK approximates to a total of $ 440 Billion (17% of world-wide total).
According to the Neuberger Berman Report (2014), the long-short equity hedging strategy is returning to “alpha” bent returns as the correlations between stocks are showing a declining trend globally and have stayed at these levels of moderation from late 2012. According to HFR (2014) HFRX Equity Hedge Index showed a rise in performance by 11.14% in 2013 over 2012. The following graph shows the rolling one-year stock correlations vs HFRX equity index:
Lower correlations help managers as this implies a raise in the importance of company fundamentals to the stock performance.
Some of the top performing hedge funds with long-short equity hedge trading strategies include Blackrock, Marshall Wace, etc.
. WHAT IS LONG SHORT EQUITY HEDGE STRATEGY
Fung et al (1997) classified a hedge fund’s strategy in terms of their style and location. Style refers to the asset position that a fund manager takes eg. going short, long, staking on a specific type of corporate event, retaining market neutrality, etc. Location would mean the asset class that a hedge fund normally invests in like fixed income securities, equity, currencies, etc.
Another way of classifying funds is according to their nature. Market neutral funds refer to those funds which are not much impacted by variations in the overall market returns ie they have a low level of correlation with the return of the overall market. Directional funds share a high correlation with overall market return due to their very nature of taking stakes on movements in the market (Connor et al, 2005).
Barclay Hedge (2014) explain equity long-short strategy as an strategy for investment , primarily used in hedge funds which takes long positions in stocks which the manager expects to result in an increase and taking a short position in a stock which the manager expects to reduce in value. Taking a long position in a stock refers to buying a stock, which would result in a profit, if the price increases tomorrow. Taking a short position in a stock would refer to a situation where stocks are borrowed and sold in the market, hoping the stock to decline in value in the future. When the stock declines, the shares will be bought and returned back to the lender of shares. If the size of these positions taken are equal in value and the expected market movements occur, the hedge strategy results in a profit to the fund. This will be advantageous even if there is a decline in the market trends, if the fall in the long position is lesser than that in the short. That is the short position has to be outperformed by the long position. Accordingly, the aim is to minimize the exposure of risk to the unpredictable movements in the market and also to make the most from the spread i.e. differences in the prices between stocks.
Connor et al (2005) also explains a long-short equity type of strategy. He explains that the fund manager can take advantage of both over-valued as well as under-valued securities. He can fully concentrate on selection of securities to get absolute returns. At the same time, he can also reduce his market risk exposure by offsetting long and short positions. This provides additional leverage to such kind of portfolio.
This can be understood better with the help of a hypothetical example. Suppose the manager takes a £ 1 Million long on GlaxoSmithKline PLC (GSK) and £ 1 Million short on Astrazeneca PLC (AZN), both of which are large pharmaceutical companies listed on the London Stock Exchange. Given these positions if the market dips, it will result in a loss on GSK and a gain on AZN. On the contrary, if the market rises, there may not be much effect as both the positions may balance out each other. So, the actual reason why the investor would take such positions would be because he thinks that GSK would perform better than AZN going by the actual company fundamentals. Such strategies with equal dollar long and short positions are called market neutral strategies. Not all managers would go for neutral strategies. Some managers would retain a long bias, called “130/30” strategies wherein the manager would hold an exposure of 130% in long positions and 30% to short. These prove to be very advantageous when the markets are continuously showing a rising trend. Some managers may also resort to having a dedicated short bias when the markets show a continuously declining trend.
The following figure shows how long-short strategies have been providing a more efficient exposure to the markets:
*Measured by the indexes’ Standard Deviation
Source: Morning Star Direct
The performance of Long/Short Equity Hedges across the various stock exchanges is shown below:
Source: Credit Suisse (2014)
The Cumulative returns and drawdowns graph are reproduced below from Credit Suisse (2014):
The other statistical data on long/short equity hedge funds like annualised standard deviation, sharpe ratio, correlations, etc are reproduced below from Credit Suisse (2014):
Having a long-only portfolio exposes to more risk that ...
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The following figure shows how long-short strategies have been providing a more efficient exposure to the markets:
*Measured by the indexes’ Standard Deviation
Source: Morning Star Direct
The performance of Long/Short Equity Hedges across the various stock exchanges is shown below:
Source: Credit Suisse (2014)
The Cumulative returns and drawdowns graph are reproduced below from Credit Suisse (2014):
The other statistical data on long/short equity hedge funds like annualised standard deviation, sharpe ratio, correlations, etc are reproduced below from Credit Suisse (2014):
Having a long-only portfolio exposes to more risk that can be offset by taking a short position which reduces correlation with market conditions (Connor et al, 2005). The long-short equity hedge type of strategy can be of the following types, classified according to the focus of the fund managers (Kourbetis, 2010):
* Growth: In this type of strategy, the manager focuses on equities having strong growth potential. He invests in companies which are expected to experience a strong increase in their earnings per share. The decision making may be based on factors such as basic fundamentals of the Company or technical factors such as stock price momentum. The stocks involved in this strategy are commonly small to mid-size stocks rather than large-cap ones. Managers who employ this strategy could use this along with other strategies like short-selling; however a long-bias is common in its usage.
* Opportunistic: In this type of strategy, the manager resorts to adopt changing his strategy to take advantage of current market conditions and investment opportunities. This is due to the varying nature of the characteristics of the portfolio like the market capitalisation, asset classes, etc, which change with time. This could be adopted with a combination of different approaches at a time.
* Short Selling: In this type of strategy, the manager aims to take advantage of falling stock prices. Thus, he focuses on maintaining a net short exposure in his portfolio ie. He supplies more capital to support short positions than investing in securing long positions. Short positions are taken for securities that he believes will fall in value. For short selling, the manager initially borrows shares from a prime broker and then immediately sells the shares in the market. When the share prices fall, he repurchases them and then returns them to the broker. These kind of strategies normally target over-valued stocks ie the fund manager believes that these kind of stocks are priced too high, given the fundamentals of the underlying companies.
* Value : In this type of strategy, the manager selects stock which have a potential to change in the near future and stabilize close to the Company’s intrinsic worth. He perceives that stocks are currently over-valued or under-valued due to investor perceptions, wrong analysis by stock analysts, etc. Due to this scenario, the manager invests in a long position on undervalued stocks and takes a short position on overvalued stocks. With time, as the market comes to understand the stock better, the prices of under-valued stocks rise and over-valued stocks fall.
Characteristics of long-short equity hedge funds include:
- Not being completely market neutral
- Flexibility to the manager to choose market exposure
- Reduces risk exposure
- Generates absolute returns
Variants of this type of strategy include:
. Pairs trading: It generally involves purchase and sale of two similar securities in combination, which were equally valued at a certain point of time; but have now drifted away (one gets over-valued and the other under-valued) due to occurrence of a pricing irregularity not relating to company fundamentals (Connor et al, 2005). It results in a positive pay-off as and when the market contracts and corrects itself, resulting in both the stocks to converge themselves irrespective of the movements in the market. This kind of trading strategy is not limited to only the equities market, but can deal in any type of securities.
. Dedicated Short Bias: Another variant of this kind of strategy is the dedicated Short bias. This works very well when markets show a declining trend, since in this kind of strategy the managers concentrate on the short more (Connor et al, 2005). This results in sacrificing the market neutrality feature.
. GENERATION OF RETURNS & COSTS INVOLVED:
Long-short equity hedge funds have historically been known to generate equity –like returns with lower volatility and shallower high to low declines. Returns generated on long-short equity hedge strategies come from directional or spread bets on the market. Other factors influencing returns are price momentum, market activity, etc. In this kind of long-short equity hedge strategy, the manager targets to make returns from falling stock prices too. He re-purchases the sold stock at a price which is ideally lesser than the price that he sold the stock for, thus generating profits on it. This method is commonly referred to as Short Selling. Thus, in this type of strategy, the manager generates returns when the stock prices of under-valued long positions rise and when the stock prices of over-valued short positions fall.
Per Eurekahedge (2004), there could be three types of potential outcomes or returns by investing in a long-short equity hedge. In the first case, if the long positioned stock rises in terms of value and the short positioned one declines, it is called the most favourable outcome termed as “double alpha”. In the second case, only one side of the portfolio moves favourable and generates a net positive return. This is called ‘single alpha’. The third type is when neither occur called “double splat”.
Horejs (2011) explains the returns derived from employing these kinds of strategies. He finds that the return from these kind of strategies is the sum of return from exposure to market (beta) and any addition in value resulting from timing the market or stock-picking. Further, fees for management eat into the share of returns for investors. Thus, sources of returns in these kind of strategies include the alpha on long and short position, dividend income on long position, rebate on short position i.e. the interest earned on short sale proceeds minus brokerage & lender fees and expenses, interest earned on liquidity buffer, etc. Further, the costs of borrowing shares, margin costs on short positions taken would be deducted to obtain the net returns from these funds. Hedge fund Management fee structures are famously termed as “2 and 20” i.e. 2% annual management fee on Assets under management (AUM) and 20% of profits along with operational expenses. Expenses may include legal fees, organizational costs, marketing and distribution costs, etc apart from the management fees. However, in a test conducted by Morning Star to see how overall portfolio can undergo a change by inclusion of long/short hedging strategies, results showed that a greater allocation of long/short equity perked up the portfolio’s returns adjusted for risk in the last 10 years.
. RISKS INVOLVED
The degree of assumed risk of a hedge fund is closely related to the type of strategy adopted by its fund managers.
The risks involved in the Long-short equity hedge strategy are related to the following occurrences:
Risks in Short -sales: Some of the risks that could be incurred are unlimited loss potential, stock loan difficulties, “call-in” of stock, call for more margin due to sudden rise in prices, short squeezing due to sudden sharp increase in prices, etc. Due to market stability conditions, some of the countries have imposed a ban on short-selling or naked short-selling for e.g. France, Italy, Spain, Belgium, etc.
Rarely market-neutral: Since these strategies are rarely market neutral, they typically are either long-bias or short-bias. Thus, they are prone to having either a positive or negative market exposure risk (Connor et al, 2005).
Style risk: Long-short strategy type funds are mainly affected by specific equity price risk,if dealt with the equity class of assets. The investment is subject to precipitous losses (Blackstone, 2013). For eg. If an investment of $ 1000 loses 50%, its value would decline to $500. Subsequently, on a rise by 50%, the value would go only to $750, which would look to be a gain, but is actually $250 short of the actual cost. The investor would need to have a 100% gain to actually break-even.
Industry Factors Risk: Equity trading type may increase the correlation with broad indices, thus making the fund more susceptible to risks in particular industry sectors or global regions. Past performance may not be an indicative of future results.
High Dependency on Managers’ skills: This type of strategy completely focuses on stock selection and hence investors tend to depend a lot on skills of experienced and talented managers. In times of stressed markets or highly volatile markets, investors are subject to a lot of risk due to this factor.
Liquidity Risk: Hedge funds normally face a liquidity risk than mutual funds, since in their case, shares are not easily saleable.
High Losses: Since they are susceptible to high level of risks, they also could incur high losses due to uncontrollable market movements.
. MEASURING RISK:
Per Connor et al (2005), many of the portfolio managers are more concerned with active risk management. Active risk management is the management of active returns, which is total return minus benchmark return. However, the investors are concerned with both total risk management as well as active risk management, to keep a tab on both the whole risk of their investment as well as to know whether the portfolio manager has properly allocated funds and positioned his stocks across benchmarks. For hedge funds, there is no variance between total risk and active risk as the benchmark return is free from risk.
Variance-based approach and value-at-risk approach are two risk approaches which are generally used by fund managers to measure portfolio risk.
Variance based approach use the statistically calculated factor, Variance, to measure the risk of the portfolio. Variance is the expected squared deviation of the return from its mean. If the portfolio return is normally distributed, then the variance of the return fully represents the riskiness of the return. If the returns are very different from the normal distribution, then this approach may not be very useful. Thus this approach does not work well for derivative funds or portfolios with derivatives since they lack normality. Since most of the hedged funds contain derivatives (except certain plain vanilla futures), this approach may not be very useful for hedge funds.
Another approach called Value-at-Risk (VaR) was proposed for risk measurement to monitor hedge fund risk and protect against extreme events. It is described as the maximum loss that would require to be borne for a given time period at a given level of probability (Connor et al, 2003). The strength of VaR lies in it its general nature. It works for non-linear models and portfolios containing derivatives. The disadvantage in this kind of approach is that it is difficult to estimate the true probability of events with low probability. More comprehensive methods like Stress testing to explore the source and measure the severity of events with low probability have been prescribed as additional hedge funds assessment techniques. Stress tests are computerised tests that examine what-if simulations of a portfolio’s reactions to extremely adverse market conditions. They measure impact of simultaneous adverse changes on prices, bond yields, forex rates, volatility and correlations on portfolio value.
Adrian (2007) also prefers measuring risk based on cross-sectional dispersion of returns, which is termed to be the volatility of the returns across funds at each point of time. It uses indicators such as volatility, correlation and covariance.
. PERFORMANCE MEASUREMENT
Due to the massive expansion in the hedge fund industry, there is a requirement to develop benchmarks against which performance of a particular hedge fund can be compared with. The other need of benchmarks arise when performance of hedge funds have to be compared with other classes of assets. This has given rise to the development of hedge fund indices which are currently calculated by third parties such as Credit-Suisse, Greenwich, Hedge Fund Research, etc (Connor et al, 2005). The most frequently used is the HFRI Equity Hedge Index (Blackstone, 2013). Though these are frequently used, they suffer from limitations like survivorship bias (ie. The index may not be representative of returns from all funds since the low-performing ones tend to leave the index), heterogeneity (ie not all funds are comparable or alike) and limited data and selection bias (ie many hedge funds fail to report to indices, thus skewing the picture due to their significant impact, if any), etc.
Sharpe Ratio is a generally used statistical tool that measures risk-adjusted performance. It is the return from the portfolio above the risk-free rate, which is adjusted for risk. Annualised Standard Deviation helps in estimating this risk. Higher the Sharpe ratio better is the performance. Khanniche (2008) states that hedge funds look very attractive as estimated by means-variance approach since their average means are greater than those of stocks and bonds. Their average standard deviations are lower than those of indexes of stock markets and their Sharpe Ratios are good. However, when their skewness and kurtosis coefficients are calculated, it is found that both these are substantial in the hedge funds return distribution. Thus the performance distribution of these strategies is far from being normal. Thus the research finds that volatility cannot be considered as a relevant measure of hedge funds risk and hence Sharpe ratio cannot be considered for measuring performance, since it has a tendency to overestimate it. She finds that instead of Sharpe Ratio, performance measurement by using Downside Risk and Sortino ratio would prove helpful. Downside Risk indicator takes into account asymmetric risk and concentrates only those returns that are below are certain threshold as acceptable. By replacing volatility by downside risk in Sharpe ratio, we derive the Sortino ratio. It is the return which the portfolio generates above the threshold performance, adjusted for risk, measured by downside risk.
The other performance measurement models include the Capital Asset Pricing model (CAPM), multi-factor models, Carhart’s model, etc as discussed by Capocci et al(2004)
. CONCLUSION
The introduction of hedge funds has made the investment markets more exciting, innovative and competitive. It has resulted in exploring and exploiting a lot of talented managers who have been compensated with lucrative packages and heavy capital inflows.
Over the last 20 years, the market risk (Beta) of HFRI Equity Hedge Index to the S&P 500 has been approximately 0.45, signifying that it normally moves around half of that of the broad market. This gives elasticity to the managers to take advantage of more efficient exposure to equities. Thus, for long-short managers, the challenge is to determine the optimal level of market participation, through using tools such as Shorts, leverage etc. to overcome the volatile trends in equity pricing (Blackstone, 2013).
Given the helpful environment for stock-pickers, the forecast for the performance of Long-Short Equity strategies in the hedge fund industry has been positive (Durden, 2014). This view is also supported by Neuberger Berman Report (2014) which provides a positive strategic outlook for long-short equity hedge trading strategies. They say that lower stock correlations and greater valuation spread will enable such strategies to generate more “alpha”. It further states that in case there is market pull-down, a fine short position of this kind of strategy would ideally help in minimizing the downside impact of the market conditions.
. REFERENCES
. Adrian T. (2007), Measuring Risk in the Hedge fund sector, Current issues in Economics & Finance, 13(3), pg 1-7.
2. BarclayHedge (2014), ‘Hedge Fund Strategy – Equity Long-Short’. [Online] Available at http://www.barclayhedge.com/research/educational-articles/hedge-fund-strategy-definition/hedge-fund-strategy-equity-long-short.html [Accessed on 8 April 2014]
3. Blackstone (2013), ‘Taking Stock : Long/Short Hedge funds and “Equity Replacement”’, Blackstone. [Online] Available at http://www.cfainstitute.org/learning/products/publications/contributed/altinvestment/Documents/bx_takingstock_blackstone.pdf [Accessed on 7 April 2014]
4. Capocci, D., & Hübner, G. (2004). Analysis of hedge fund performance. Journal of Empirical Finance, 11(1), 55-89.
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7. Durden T. (2014), ‘Which Hedge fund strategies will work in 2014 : Deutsche Bank’s take’, Zerohedge. [Online] Available at http://www.zerohedge.com/news/2014-02-11/which-hedge-fund-strategies-will-work-2014-deutsche-banks-take [Accessed on 8 April 2014]
8. Eurekahedge (2004), ‘Hedge Fund Monthly : Long/Short Equity hedge funds – Strategy Outline’ [Online] Available at http://www.eurekahedge.com/news/04may_archive_japan_long_short.asp [Accessed on 7 April 2014]
9. Fung, W., & Hsieh, D. A. (1997). Empirical characteristics of dynamic trading strategies: The case of hedge funds. Review of financial studies, 10(2), 275-302.
0. Khanniche, S. (2008). Measuring Hedge Fund Risks, ICFAI Journal of Financial Risk Management, 5(2), pp 50-69.
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