Clearing fog from the secretive, dynamic hedge fund industry

Friday 15th March 2002

Hedge fund strategies are a source of confusion to many investors due to the jargon involved and the opacity of hedge fund trading operations.

Some 6000 hedge funds are now thought to exist, with about $US500 billion under management, but no one knows for sure what the real numbers are.

The hedge fund industry is less well-regulated and therefore not as transparent as the better-known markets for bonds and shares.

It also tends to be secretive for the reason that profit opportunities suffer if too many other players know about them and try to jump on board.

Some clarity has been introduced into what goes on with hedge fund trading by David Zobel, head of Deutsche Asset Management's Australian branch of Absolute Return Strategies.

Hedge funds are also called absolute return funds because they seek to make a profit regardless of whether markets are rising or falling. Heavy reliance on derivatives and short-selling is applied to profiting from markets whatever the prevailing trend.

Mr Zobel is in New Zealand to promote the new Tower managed funds product, the Advantage Hedge Fund. The fund is based on Deutsche Assets Management's own Deutsche Offshore Strategic Value Fund.

According to Mr Zobel, no matter what fancy industry names get applied to hedge fund activities, there are four basic categories into which absolute return strategies can be classified. These four strategies are briefly described as follows in ascending order of average risk and return characteristics.

First, there are relative value absolute return funds. These operate mainly in the bond and share markets and seek to profit from simultaneous trading of pairs of investments which are perceived to be mis-priced in relation to each other.

The underpriced asset is bought (the "long" position) and the over-valued asset is sold short (the "short" position).

If the trade succeeds, eventually the two investments converge in value and a profit is booked.

Relative value strategies are "market neutral" in that they arise independently of overall market trend, whether rising or falling.

Sub-categories are convertible arbitrage, which works on mis-pricings between shares and their related convertible bonds; fixed income arbitrage, which trades on value differences between interest-bearing securities like bonds; statistical arbitrage, which looks for mathematically-determined price anomalies between securities that are thought likely to revert to historical norms; and rotational strategies, which use all three possibilities.

Second, there are event-driven strategies. These are also market neutral and rely on special situations arising for shares.

One sub-category is merger, or risk, arbitrage, in which shares of the company under offer are bought. If the deal is stock-for-stock, shares of the offering company are often simultaneously sold short on the assumption of profitable price convergence if the deal is consummated.

Another variation is distressed debt, in which an indebted company is in or close to bankruptcy and its debt is selling at under face value. The trader will buy the debt if it is thought under-valued and sell it short if it is believed over-priced.

Third, there are long/short equity strategies in which managers maintain a mix of shares that are bought and those which are short-sold. Long/short equity is the oldest type of hedge fund trading, with the first absolute return fund in it having been set up in 1947.

Varieties include US opportunistic and global opportunistic strategies, which stock-pick on market outlook; US sector, which tends to be biased to long positions; and short-biased, in which short-selling predominates, an approach best suited to bear markets.

Mr Zobel gave as an example of a potential long/short equity universe the New Zealand sharemarket, which even in recent up years nonetheless has had about 40% of listings fall in value, giving rise to many short-selling possibilities. Long/short equity is not always market neutral because it often requires the manager to take a view on market trend.

Fourth, there are global macro strategies, which involve taking a trend view on markets and economies. Traders are likely to range over all securities markets, such as global equity, fixed income, currencies and commodities.

Sub-groups are discretionary, which has the widest brief in terms of trader choice across markets; and systematic, in which managers use proprietary, quantitative methods to find mis-pricings and usually specialise in one type of securities market only.

Global macro is the highest risk/return absolute return strategy and is identified with the likes of George Soros.

Mr Zobel observed that over the past 10 years global macro had declined from about 60-70% of the total hedge fund universe to about 15% today, with the other three categories mentioned above now being significantly more prevalent.

The hedge fund industry is clearly dynamic in its development and a source of endless fancy phrases to describe what is going on behind the scenes. Mr Zobel's concise glossary of the basic types and sub-types can make for smart conversation at the dinner table as terms like relative value, event-driven, long/short equity and global macro are bandied about to amaze listeners and inspire admiration.

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