Hedge funds diversify

Active investment as practised by hedge funds is now decidedly not the traditional asset management model of a fund putting all of its cash into a portfolio of 100 or so different stocks.

Negotiating the volatile markets of the past year has been a difficult task, and the sheer number of hedge fund strategies now being practised clearly demonstrates how many ways there are to achieve similar investment goals.

As a result, lumping all hedge funds into one category is becoming increasingly meaningless as the investment strategies they pursue become more diverse and complex.

The rise of technology has also made it possible for managers - even those with only basic infrastructure - to follow complex investment strategies that require the processing of huge amounts of data.

In August 2007 several quantitative hedge funds that use complex computer driven models to make their investments found out that their models could perform poorly in times of extreme market volatility. Nevertheless, investors seem prepared to take the downside risks in the knowledge that, more often than not, such funds tend to outperform the wider markets.

Distressed investing

In the wake of the US subprime mortgage meltdown and the ensuing credit crunch, an area that is likely to attract particular interest in the coming weeks is distressed investing.

Distressed managers invest mainly in companies or securities connected to them that are encountering significant financial or business difficulties, including companies that may be engaged in debt restructuring. They also look at companies that have posted poor financial performance as a result of factors such as poor operating conditions over-leveraged capital structure or catastrophic events.

Convertible arbitrage

Another style of hedge fund investing that is proving popular is convertible arbitrage, which involves taking long positions in convertible securities and hedging those positions by selling short the underlying common stock.

The timing of such trades may be linked to a specific event concerning the company in question. Convertible securities and warrants are priced as a function of the price of the underlying stock, expected future volatility of returns, risk free interest rates, among several other variables, giving the potential for mispricing.

Macro strategies

Some of the most successful strategies of recent times in the hedge fund market have been so-called macro strategies. These attempt to identify extreme price valuations in stock markets, interest rates, foreign exchange rates and physical commodities, and make leveraged bets on the anticipated price movements in these markets.

In order to identify these extreme price valuations, the managers of such funds - which include some of the most famous hedge fund managers such as George Soros and Bruce Kovner - generally employ a “top-down” approach, which concentrates on forecasting how global macroeconomic and political events might influence the valuations of financial instruments.

The strategy has a broad mandate and gives manager the ability to hold positions in practically any market with any instrument. Profits are made by correctly anticipating price movements in global markets and having the flexibility to use any investment approach to take advantage of extreme price valuations and movements.

March this year saw macro managers suffer their first minor setback in months, as some managers were caught out by sudden declines in the prices of several commodities. However, macro funds remain the only strategy subset in positive territory over the year to date, up over 10 per cent.

Making the most of volatility

The rise of volatility in markets over the past year has led to a rise in strategies aimed at capitalising on or hedging exposure to this volatility. Such strategies include funds employing arbitrage, directional, market neutral or a mix of types of strategies, and include exposures that can be long, short, neutral or variable to the direction of implied volatility. They can include both listed and unlisted instruments.

Hedge Fund Resreach, a hedge fund data service, says directional volatility strategies maintain exposure to the direction of implied volatility of a particular asset or to the trend of implied volatility in broader asset classes. Arbitrage strategies employ an investment process designed to isolate opportunities between the price of multiple options or instruments containing implicit optionality.

The race is on

In a report published recently, Merrill Lynch said he asset management “race is on” as hedge funds and traditional asset managers compete in a “converged” industry where the lines between long-only, private equity, hedge funds and other alternative asset classes are becoming increasingly blurred.

Against this backdrop, the ability of hedge funds to differentiate themselves through the complexity and thoroughness of their various investment strategies, might be enough to keep them one step ahead.