Hedge Fund Strategies

Most of the time, hedge funds are lumped together under one umbrella.  While the aims of fund managers are basically the same, the methods can be very different.  By methods, I mean investment strategies.  There are four main categories of strategies:  market directional, event driven, arbitrage and opportunistic.

Market directional strategies are affected by the securities markets.  When the term hedge fund is mentioned, the investing public immediately thinks of two of them - equity long/short and short.  The former allows the portfolio manager to have both long and short positions within the fund while the latter has short positions.  The other two are less popular - activist and emerging markets.  The activist hedge fund tries to improve the management of its positions and profit from the subsequent rise in stock price.  The emerging market fund invests in its namesake.

Corporate restructuring (aka risk arbitrage) funds invest in companies undergoing a current or possible transaction.  The most well known strategy is merger arbitrage which is based on a merger between two companies and whether or not it will be completed.  The distressed securities strategy invests in companies that are being re-organized or are in bankruptcy proceedings.  Event driven funds invest in companies that are going through mergers, bankruptcy, spinoffs, re-organization, special dividends or stock buybacks.  Regulation D invest in securities issued through private placements such as through rule 144A.

Arbitrage funds identify two similar securities with different prices will converge to the same price.  The main strategies are fixed income arbitrage, convertible bond arbitrage, equity market neutral and relative value arbitrage. The first two capture price discrepancies between buying a security (bond or convertible) and hedging that position by shorting a similar security.  Equity market neutral combine long and short positions in a portfolio to eliminate market risk.  Relative value arbitrage strategies find a relationship between the prices of two securities.  When there is a discrepancy to the historical pricing, the funds seeks to take advantage of it and profit when the relationship returns to the norm.

Opportunistic strategies are global macro and fund of funds.  Global macros managers take a top-down investment approach.  They look at macroeconomic factors and invest accordingly.  Funds of funds invest in other hedge funds.  Depending on market conditions, they are able to re-allocate capital to generate superior returns.

We will take a closer look at these strategies in later entries.  There are other strategies that are not as  common and we may review them too.

Hedge Funds and their 13F filing data

A number of articles have focused on investment banks and how their prime brokerage divisions service hedge funds.  I came across this article a couple of weeks ago regarding 13F filings by hedge funds.  Hedge funds report their holdings to the SEC on a quarterly basis.  Christopher Holt of the website AllAboutAlpha.com has an interesting article regarding the trading volume and performance of securities on funds' reports after publication of the filing information.  You can access the article here.

A Little Trader Talk

I wanted to make a quick point on a post based on a conversation I had with a colleague.  We sat on the trading floor near one of the sales trading desks and they were, as usual, shouting out orders the entire day such as 1,000 shares of Microsoft.  My colleague remarked, "They don't seem to be trading much money.  1,000 shares times $47 is $47,000."

When traders yell out orders on the floor, the share amounts are in thousands.  So, 1,000 shares is actually 1,000,000 shares.  If the number of shares are less than 1,000, they are called little shares.  A 500 share trade would be 500 little shares of Microsoft.

Private Placements under Rule 144A

Investment banks may sell restricted securities to large investors with over $100 million in assets (called Qualified Institutional Buyers or QIBs) based on Rule 144A.  This is a private, low-key transaction that is not advertised like an IPO.  There is no management roadshow to promote the issuer.  Most of the times, they are done within a short timeframe.  When these transactions occur, the sellside firm first must affirm that the buyers are QIBs.

These securities are not registered with the SEC and do not have to provide a full prospectus to the buyers.  Instead, an offering memorandum is prepared.  This document has a description of the issuer's business, financial statements and management's analysis of the most recent results.

A large number of these transactions are done for preferred convertible bonds and for ADRs (American Depository Receipts) or GDRs (Global Depository Receipts).  This is an method for non-US companies to access US capital markets without having to submit to US disclosure laws.

Is There Any Way to Attribute Revenues for Corporate Access?

One of the items valued by the buyside is access to corporate management.  As was stated before, this could be a meeting or presentation at a conference or non-deal roadshow.  After either event, how can the sponsoring investment bank confirm that the buyside client is doing more business i.e. trading commissions?  The bank can check the before and after revenue levels in regards to the trading activity for the issuer.  There are certain caveats that must be taken into account.

• If the security is lightly traded, then the fund manager may execute trades in a more heavily traded stock to pay for the meeting.
• If the meeting merely caused the fund manager to keep the current holding, then the manager may execute trades in another security to pay for the meeting.
• If the trading desk for the sponsoring bank does not give "best execution" for the security, the manager may execute trades in another security to pay for the meeting.
• A better metric may be to calculate the trading market share of a security.

Studies in Client Profitability

We have reviewed the broker vote and the main factors that contribute to it.  The next logical step is to analyze them and determine if the investment bank is receiving a good return on its allocation in resources.  It's a simple revenues versus expenses calculation.  The art is in determining what the expenses are and how to weight them.  What services are the most important and bring the most value to the buy side?  How much does each service cost?

Within the financial services industry, the most expensive costs are people's time.  For the main roles that interact with the buy side, banks would measure:

Research Analyst - 1x1 meetings, group meetings, field trips, projects/special reports, 1x1 calls, conference calls, entertainment
Research Sales - calls/time spent on client, entertainment
Salestrader - calls/time spent on client, entertainment

For Corporate Access, the statistics would include 1x1 meetings, 2x1/3x1 meetings, group meetings, field trips, presentations, conference calls, special events and entertainment.

In addition to the basic profit/loss analysis, there are scenarios run to estimate revenues if the resource allocation changes.  If a fund is given more meetings, what is the upside in revenue?  What is the downside in revenue if resources are cut?  How should we approach a client who is not giving the firm enough revenues to merit the resources that are given to them?  Here is where senior management needs to make hard decisions.  This is usually the province of a relationship manager for large accounts and sales management for others.  We will discuss the role of the relationship manager at a later time.

How Technology Can Serve Hedge Funds

A prime broker is able to offer hedge funds its technology resources to facilitate its daily operations.  The fund managers are allowed to concentrate on running their funds by outsourcing them.  Here are some functions that the prime broker offers funds.

Reporting

Prime brokers offer bespoke reporting with the ability to analyze the fund's whole portfolio.  The reports can measure the performance of the fund, calculate the Net Asset Value (NAV) and provide risk management reports in real-time.  They can run performance reports comparing the cost of a trade against an industry benchmark (i.e. VWAP or TWAP).  Being able to calculate the value across all positions allows for accurate portfolio margining.

Trading

Prime brokers can give hedge funds access to their electronic trading platforms.  These include direct market access (DMA), algorithmic trading and program trading.  The best platforms allow fund managers to execute their trades anonymously and without affecting the market.  Credit Suisse's Advanced Execution Services and Goldman Sachs' REDIPlus are the best that are out there.  The field is very competitive and every firm is constantly improving their services.  Speaking of anonymity, there are a number of dark pools run by investment banks such as Credit Suisse's Crossfinder and Goldman Sachs' SIGMA X.

Research

Prime brokers offer access to research created by their equity, fixed income and derivatives analysts.  This can be distributed through the banks' proprietary web portals.

Custody and Trade Settlements

One of the basic functions that a prime broker performs for a hedge fund is to act as a custodian for its assets and to settle its trades.  The custodian holds the fund's stocks, bonds, commodities, etc. in a separate account.   As a result of the Lehman bankruptcy, there have been discussions of how to safeguard these assets better.  Some funds were unable to retrieve the assets that were embroiled in the bankruptcy procedure.  Because of this risk, managers are having 3 or more prime brokers handle their funds.

The prime broker processes and settles the fund's trades with different counterparties.  Since the broker clears all the trades, it is able to give the fund manager centralized reporting.  The global brokers will be able to handle trades across different countries and products (such as equities, fixed income, commodities, foreign exchange, futures, options, warrants, credit default swaps, equity swaps and other over-the-counter derivatives).  It also handles corporate actions on securities.  These actions include:

• Mergers and spin-offs
• Tender offers
• Dividends and interest payments
• Calls on bonds
• Stock splits
• Annual meetings and proxy communications
• Accounting i.e. calculation of Net Asset Value (NAV)