In the previous article, we introduced the concept that hedge funds offer opportunity through diversity and alluded that hedge funds are not a homogenous asset class. Buying one does not translate to buying all. Even within each style, the returns can be vastly different.
That being said, the ultimate aim of each of the hedge fund strategies is to make money with little excuses to underlying market environments. Each utilise their “degrees of freedom” or ability to utilise a larger toolbox of trading methods than their long-only brethren. These include the ability to short sell and/or apply leverage to generate returns while limiting downside losses irrespective of the direction and trend of markets.
With over 100 different HF products available, selection does become a little harder and requires some intimate understanding.
We take a closer look at the heterogeneous nature of hedge fund strategies, what drives this distinction and in turn demonstrate where each looks to deliver value for the investor.
Long Short Equity
Making up roughly 60% of industry size, these are the most commonly referenced type of hedge fund strategies and are often the default understanding of how a hedge fund is defined.
The kernel of these strategies and point of difference from traditional equity strategies lies in their ability to “short” – selling stocks now that are expected to move down in value at a later stage. It is strategies such as these that saw many hedge fund investors rewarded in the share price decline of African Bank. Further tools that avail themselves to achieve this include futures, options and other derivatives.
Typical categories of Long Short Equity strategies are:
Long Short Aggressive
Long Short Conservative
Market neutral; with the distinction that the long and short positions are generally matched to the same value within the same sector.
Most of us understand fixed income to be the generic and typically conservative income related or bond funds. Despite using instruments within the fixed environment, the returns experienced from these strategies seldom feel and demonstrate anything similar to their long only counterparts.
Representing roughly 15% of industry assets, their unique return signature is largely driven by their ability to take advantage of perceived mispricing in the fixed income market.
Their degrees of freedom are mostly executed in their ability to leverage or gear their holdings. Given the relatively lower dispersion of returns from fixed income assets, the leverage is key to “sweating” the 2 or 3 basis point mispricing to generate returns of substance.
Managers of these strategies are yield curve traders, with the respective strategies defined relative to where they trade on the yield curve:
Short-end specialists: These strategies trade yield curves in the region of maturities from 0 to 2 years. Managers that trade these do so on the basis of expected interest rate changes from the Monetary Policy Committee (MPC). So if for instance, a hedge fund manager expects the MPC to raise interest rates however market expectations don’t reflect this expectation, the manager will take advantage of this mispricing. Despite trading money market expectations, the managers in this environment have shown the potential to outperform equity markets with equity-like risk.
Long-end specialists: These strategies trade yield curves in the region of maturities from 2 to 30 years with the bulk of activity seen in the 2-10 year maturity bucket.
Most of the managers who trade in this space do so with a “relative value” mind-set; they do not necessarily require substantial market direction but rather take advantage of short-lived mispricing that reverts to its long-standing average.
Some of of the typical trades that occur are:
5 yr Bonds vs 10 yr Bonds
5 yr Bonds vs 5 yr Swaps
3yr Bond vs 5 yr Swap vs 10 yr Bond (Butterfly)
There exist over 16,000 different permutations of these and subsequently increased opportunities for generating returns within the fixed income class. Commodities
Commodity related hedge fund strategies encompass a smaller set of differentiated and lucrative strategies that generally do not represent a significant level of market trade (4% of industry assets).
Despite the name, these strategies have very little to do with the broader global commodity cycle and the influences of China et al, but rather to do with the understanding of crop cycles and weather patterns.
Subsequently, the predominant players in this market tend to be soft commodities and agriculture specialists – the skill set for this market tends to be very different to that of most financial markets. Traditional participants are the farmers, millers and hedge funds. All this combined creates for a very niche and alpha rich environment.
Equivalent to multi asset funds from traditional investments, the multi strategy fund represent a blend of all of the above strategies – actively allocating across asset classes and managing strategies that are expected to be rewarded in varying environments. The genesis of global hedge fund strategies can be found in these strategies while funds of hedge funds also come to mind.
It all comes down to investment performance
The diverse set of hedge fund strategies have not only demonstrated diversification appeal. Over the last 15 years, their credible (net of fee) returns and improved riskmetrics relative to key market indices as well as solid performance compared to ASISA Multi Asset categories, show a compelling story.
Together with this and with careful selection, their potential complementary and return enhancing nature offer the opportunity for consideration into a balanced portfolio.