Relative value arbitrage style hedge funds attempt to capitalize on relative pricing discrepancies between related instruments in anticipation of the prices converging over time
Arbitrage is a two sided strategy involving the simultaneous purchase and sale of related securities that are mispriced compared to each other.
Convertible arbitrage style exploits pricing anomalies between convertible bonds and the underlying equity, typically long the convert and short the equity. It is designed to profit from the fixed income security and the short position in the stock. Typically employ leverage (up to 6:1) and face interest rate, credit, liquidity and corporate event risk.
Fixed income arbitrage strategies exploit pricing anomalies within and across global markets. Typically exploit investor preferences, exogenous shocks to supply or demand, or structural features of fixed income market. Include yield curve arbitrage, sovereign debt arbitrage, corporate versus Treasury spreads, muni vs. Treasury spreads, cash vs. futures and mortgage backed securities arbitrage. Typically neutralize interest rate risk and employ substantial leverage.
The equity market neutral style exploits pricing inefficiencies while exactly neutralizing exposure to market risk.Unlike the equity long/short style, market neutral funds seek to have low correlation to traditional assets. Equity long-short funds typically exhibit some beta.
The index arbitrage style exploits mispricings between the index and index derivatives.
The mortgage-backed securities arbitrage style seeks to profit from the pricing difference between a mortgage instrument with uncertain prepayment and credit quality characteristics, and a non-prepayable Treasury security.
Posted on 3rd September 2010
Under: Active Management, Alternative Assets, Hedge Funds | No Comments »
Hedge funds are privately organized, loosely regulated and professionally managed pools of capital not widely available to the public.
Posted on 3rd January 2010
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Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.
Event risk relates to unexpected company-specific or situation-specific events that affect valuation.
Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.
J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.
Posted on 28th November 2008
Under: Active Management, Alternative Assets, Investing in Distressed Securities, Portfolio Management, Risk Management | No Comments »
When considering an investment in private equity, investors need to consider a number of factors.
- Can a small investor obtain the diversification needed
- Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
- Will the investor be able to fund promised commitments to the private equity fund when called for
- What mix of sector, stage and geography is required to provide the best diversification
In addition, selecting managers requires special due diligence considerations:
- Can the investor and manager evaluate prospects for market success
- Understanding of the markets, competition and sales prospects
- Experience and capabilities of management team
- Management’s commitment – ownership, compensation structure, etc
- Opinion of customers
- Identity of current investors – do they have particular expertise that lends confidence to outsiders
- Operational review
- Have experts validated the technology
- Consideration of employment contracts
- What intellectual property rights have been established
- Financial and legal review
- Potential dilution of interest
- Financial statement (or tax returns, or investor-conducted audit)
Posted on 27th November 2008
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Investors seeking exposure to securities issued by companies in distress are typically seeking higher returns in exchange for the added risks. Success in distressed security investment requires unique skills, and typically investors participate via vehicles such as hedge funds or private equity funds. Hedge funds offer greater liquidity for the investor (and greater access to capital for the manager.) However, the illiquid nature of many distressed securities may confer advantages to the fixed term and closed-end structure of private equity funds.
There are a number of security types that relate to distressed companies:
- The publicly traded debt and equity
- Newly issued (orphan) equity of companies recently emerged from reorganization
- Bank debt and trade claims that the original creditor may wish to monetize
- “Lender of last resort” notes
Frequently investors use these securities in conjunction with a range of derivative products to hedge related risks.
The reasons distressed securities can offer high risk-adjusted returns relates to the market opportunity that arises because other investors are either unwilling or unable to participate in the market. Some funds are prohibited from owning speculative grade debt, and are forced to sell holdings that lose an investment grade rating regardless of price. Others do not wish to participate in drawn-out bankruptcy proceedings and will accept a fraction of the value of their claims in exchange for immediate cash. In other cases, failed leveraged buyouts or unduly shunned companies that recently emerged from bankruptcy may create a temporary imbalance of supply and demand for their securities.
Posted on 28th October 2008
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Private equity investments typically have a low correlation to the returns on stocks and bonds, which provides a diversification benefit. Investors should understand, however, that the use of appraisals can result in a stale valuation and could partially explain the low correlation. If annual returns are used for both private equity and traditional assets, the correlations appear higher.
Although the risk reduction benefits may be modest, the expertise required to invest in private equity usually results in a higher return on investments. Therefore, a modest inclusion in the portfolio may still be merited.
Posted on 27th October 2008
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Derivative markets are zero-sum games, with each long position offset by a corresponding short. As such, the aggregate return to all participants in the futures market is the risk-free rate, less any management fees. In order for managed accounts to earn a positive risk-adjusted return after fees implies other market participants who systematically earn less than the risk-free rate. This is possible because many participants in the futures markets are hedgers, who may be willing to accept the lower return as an insurance premium protecting them from outlying events.
Managed futures managers can also exploit mispricing opportunities that arise when certain contracts are not trading at the proper relationship to other contracts.
Even with limited return opportunities, managed futures may play a role in the portfolio due to a low correlation of returns with those of traditional investments such as stocks and bonds. The diversification benefits have been shown to accrue even for portfolios that include other alternative assets such as hedge funds.
The Sharpe ratios of portfolios that include managed futures dominate those that do not. However, the benefits may be specific to the investment vehicle, time period and strategy under consideration. Managers have been shown to demonstrate short-term persistence in returns and a manager’s beta relative to his benchmark is often a good indicator of future returns.
Since futures involve leverage and derivatives, particular consideration should be paid to risk management strategies.
Posted on 28th September 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Investment Returns, Personal Finance | No Comments »
Benchmarking the returns of private equity investments is complicated by the fact that events that would indicate a change in market value (such as a new financing, acquisition, IPO, or failure of the business) occur infrequently.
Cambridge Associates and Thomson Venture Economics provide overall indices for VC and buyout funds. They typically calculate the internal rate of return based on cash flows since fund inception. Often firms are compared by vintage year for comparability across the stage of financing and any macroeconomic influences.
Since the venture capital must provide appraisals of some assets, stale valuations can result in a smoother return appearance than is actually realized.
Posted on 27th September 2008
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Hedge funds are not required to report their performance, and those who voluntarily report can opt out of reporting at any time. There are at least two possible reasons a hedge fund might choose to stop reporting results:
- Poor performance, possibly including fund closure
- Very good performance has eliminated the need to attract capital
In the Fall 2007 Journal of Portfolio Management, Grecu Malkiel and Saha examine both hypotheses, and find a pattern of declining performance in the months leading up to cessation of reporting. Further the probability that a fund will stop reporting increases rapidly during the first five years of a fund’s life and then gradually declines from the peak. Funds with high Sharpe ratios, more assets and peer-beating performance are less likely to stop reporting.
The authors conclude that hedge funds stop reporting results due to poor performance, rather than strong performance.
Posted on 6th September 2008
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Managed futures investments are investments in commodities by professional managers using skill-based strategies. The strategies employed may be either systematic trading methods which usually are trend-following or discretionary strategies based on analysis and judgment of the manager.
Managed futures accounts are often classified according to market focus as either:
- Financial – investing in financial and currency futures and options
- Diversified – financial and physical commodities
Typically, managers are benchmarked to a group of managers employing a similar style. Investable benchmarks have also been established that rely on mechanical trend-following strategies. When comparing returns, it is important to understand that historical data is affected by survivorship bias.
Posted on 28th August 2008
Under: Active Management, Alternative Assets, Asset Allocation, Futures, Investing in Commodities, Portfolio Management | No Comments »