Significant diversification benefits can be gained by investing in a variety of hedge fund strategies because of the presence of low—and even negative—correlations between different hedge fund strategies. Such strategies can be divided into the following categories:
- Long/short
- Global macro
- Multi-strategies
- Market-neutral
- Convertible arbitrage
- Managed futures
- Market timing
- Quantitative investment
- Alternative investment currency
- Event-driven
A brief description of these hedge fund strategies follows:
- Long/short strategies serve as the active equity, bond, or mixed-equity-and-bond benchmarks for alternative investments. Long/short managers maintain positions both long and short in equities and/or bonds and also in derivative securities. They dynamically manage their exposure to long-only indices in order to be less dependent on the direction of the underlying market.
- Global macro managers invest around the world using economic theory to justify the decisionmaking process. The strategy is typically based on forecasts and analyses about interest-rate trends, the general flows of funds, political changes, government policies, intergovernmental relations, and other broad systemic factors.
- Multi-strategies managers employ a strategy that is predicated on realization of a spread between related yield instruments in which one or more components of the spread contain a fixed income, derivative, equity, real estate, or a combination of these or other instruments. The strategies are typically quantitatively driven in order to measure the existing relationship between instruments and in some cases to identify positions in which the risk-adjusted spread between the instruments represents an opportunity for the investment manager.
- Market-neutral managers seek to profit from both increasing and decreasing prices in single or multiple markets. An example of a market-neutral strategy is matching long and short positions in different stocks to increase the return from making good stock selections and to decrease the return from broad market movements. Market-neutral managers may also use other tools such as merger arbitrage and shorting sectors. There is no single accepted method employed in a market-neutral strategy.
- Convertible arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that yields a profit by exploiting price differences of identical or similar instruments in different markets or in different forms.
- Managed futures is a strategy professional portfolio managers use as part of their overall investment strategy. A managed-futures strategy provides portfolio diversification among various types of investment styles and asset classes to help mitigate portfolio risk in a way that is not possible with direct investments such as equities and bonds.
- Market timing is a strategy in which commodity managers invest in a wide variety of trades: directional trades based on an opportunistic view about prices, equity trades based on commodity-linked equities, and relative-value trades that are based on spreads observed in commodity markets.
- Quantitative investment strategies are often the most difficult to define. Some managers tweak mathematical models, or they let the “signal” proceed on its own. In other cases quant managers use current economic and financial theory to define the sources of risk and to point out where opportunities may lie. Possibly the shortest—but not necessarily the best—definition of quant investing is that it is a strategy that employs sophisticated quantitative techniques to analyze price data to gain information about future price movements. Quantitative strategies typically maintain varying levels of net-long or -short equity market exposure over various market cycles.
- While there is more than one alternative investment currency strategy, we define here the most commonly occurring one–discretionary. A discretionary currency strategy relies on the fundamental evaluation of market data, relationships, and influences as they pertain to currency markets, including positions in global foreign exchange markets—both listed and unlisted—as interpreted by an individual or group of individuals who make decisions on portfolio positions. The strategy typically employs an investment process that is heavily influenced by top-down analysis of macroeconomic variables.
- Event-driven strategies seek to exploit pricing inefficiencies that may occur before or after a corporate event such as a bankruptcy, merger, acquisition, or spinoff.
REUTERS/David Gray
Investing in a combination of hedge funds (not just in a fund of hedge funds) allows investors to have access to a large, diverse portfolio of hedge funds. The diversification benefits provided by a combination of funds are brought about by investing in funds that have a low correlation to each other. These correlations are often calculated using equally weighted fund returns and can contain a significant amount of noise that is due to the very small amount of returns data available for hedge funds.
If we apply random matrix theory (RMT) to hedge fund returns with the aim of reducing the level of noise in correlation matrices formed from these data, we can construct a combination of hedge funds with an improved risk profile.
RMT is a valuable tool for analyzing market correlations where noise can account for more than two-thirds of the correlations. Thus, many of the empirical correlations are spurious and represent measurement noise and biases. RMT can clean out these spurious correlations, and moreover it can identify the statistically significant signal or common market risk factors that drive the individual hedge fund returns. The most prominent non-idiosyncratic factor is beta, whose correlation with other securities is more than 20 times higher than the average correlation. Secondary factors are long-short portfolios of certain liquidity and industry structure, in our case individual hedge funds. Many of the correlations between hedge funds are random, so they contain little or no information about risk. We will use only those correlations that are statistically significant.
In our next article we will discuss our RMT work and the resulting groupings of hedge funds that can be labeled low, moderate, and high risk.
