Various Types of Strategies
Different types of hedge fund strategies are discussed as follows:
Relative Value of Strategies: Relative value strategies are also known as non-directional strategies. These strategies attempt to locate profit relative pricing discrepancies between instruments such as equity, debt, option and futures. The risk of these strategies depends upon how closely related the securities bought and sold are. Generally, these strategies are characterized as having low volatility and little correlation with the market. Many Hedge Fund strategies employ these strategies with leverage and look for opportunities globally.
Equity Market Neutral: This strategy is the classic Hedge Fund strategy that A.W. Jones proposed. This strategy uses combination of long and short position on stocks. The strategy is purely market timing rather than stock picking and has no correlation with the market. On the basis of fundamental analysis and sometimes, technical analysis, fund managers take long and short position on the undervalued and overvalued stocks respectively, which are going to outperform and underperform the markets. Sometimes leverage facility can be accessed to boost the returns. Volatility expected from this strategy is usually low.
Fixed Income Arbitrage: This strategy attempts to exploit mispricing among fixed income securities such as bonds, debts, treasury bills, etc., across global fixed assets markets and related derivatives. This strategy relies heavily on mathematical models of the term structure to identify mispricing and manage positions. Opportunities exist due to varying interest rates, tax residuals, yield curve irregularities, short-term volatility differences and arbitrage. Typically, a large amount of leverage is used for enhancing returns.
Convertible Arbitrage: Generally, convertible arbitrage strategy seeks to profit from arbitrage of the convertible or hybrid securities, usually bonds or preferential warrants converted into equity securities of the issuing company. This strategy profits by a long position on the convertible securities and short position on the underlying company stock.
Mortgage Arbitrage: It seeks to profit from the pricing difference between an underlying mortgage security and its credit quality, or high interest payment on early redemption, and their related derivatives. Historically, these securities presented investors with high yields with relatively low risk.
Stock Index Arbitrage: This strategy benefits from the spread available between index futures and the price of underlying securities. If the index future seems to be overvalued, the Fund manager takes long position on the basket of underlying stocks in cash the market replicating the index and short position on the index future contracts and waits till the price differential disappears, and then closes the positions at a profit.