Hedge fund trading strategy
Many managers analyze financial statements and fundamentals of companies in great detail, but there are also funds trading based on technical analysis or quantitative models. See more about equity market directional hedge funds. Relative value or arbitrage funds trade various spreads and bet on relative price differences of one security vs. Arbitrage funds typically use sophisticated computer models, as computers are faster in discovering a mispricing than human beings. The mispricing the profit opportunity is often very small and high leverage is used.
Common strategies include fixed income arbitrage , volatility arbitrage , convertible arbitrage , and equity market neutral. See more about relative value also called convergence trading hedge funds. Funds focusing on corporate restructuring trade securities mostly stocks and bonds issued by companies in special situations like distress, bankruptcy, or merger.
The securities are often not publicly traded and there may be a closer relationship between the fund manager and the company. Sometimes the fund managers get even actively involved in the decision making inside the company during the restructuring. Common strategies include trading distressed securities , event driven strategies , and merger arbitrage. Macro trading funds are funds taking directional positions in stock indices, currency exchange rates, interest rates, and commodities.
Unlike equity market directional funds, macro funds focus on broad macroeconomic developments rather than on individual companies.
Decision making tools range from studying macroeconomic fundamentals over simple technical analysis to quantitative models sometimes it is a combination of these. Macro funds often use leverage. Typical trading vehicles are futures and options. Cohen's research shows that any alpha generated by the average hedge fund is lost to an investor in the various layers of fees. TV video, Jaeger contends that hedge funds take systematic risk exposures to capital markets which lead to their premium, which he calls Alternative Beta.
The most intuitive replication methodology essentially looks at each hedge fund strategy in isolation, and qualitatively asking the question: What is the manager trying to do to generate returns?
For each hedge fund strategy, a replication strategy is put in place that attempts to mimic what the hedge fund manager is doing in a mechanical fashion.
Consequently, one would expect to generate the beta , but not the alpha, of that particular strategy. This process is carried out for each of the hedge fund strategies, and then these strategies are combined to produce a product that attempts to replicate the entire hedge fund universe. An alternative to direct hedge fund replication has been the development of trading strategy indices , which for some financial institutions, came as a further development of the hedge fund replication business.
Many trading strategy indices use similar investment styles to hedge funds, but aim to generate returns in their own right, rather than seeking to recreate the performances of the hedge fund industry. However, a diversified portfolio of trading strategy indices is viewed, and frequently marketed, as a liquid alternative to direct exposure to the hedge fund industry.
The factor replication method attempts to replicate the return stream of the hedge fund universe. The simplest way of doing this is by carrying out a linear regression , using one of the headline hedge fund indices and a number of factors. The model selects the factors that have the highest explanatory powers for the index returns, and then each month the model will perform the regression analysis over a rolling time frame, and select the weightings for each of these factors.
This method is backward looking and may miss inflection points in the market as it relies on a rolling window of returns. Improvements to this method have been suggested, such as using Kalman or Particle filters , which improve the speed at which the model reacts to change. A recent advancement of the replication community is the introduction of a benchmark index, called the Hedge Fund Replication Index, published by hedgefundreplication.
The average fund of hedge funds should therefore statistically under perform the average replicator. The Hedge Fund Replication Index has a correlation of 0.