Directional strategies - Long/Short strategies - Arbitrage strategies
The alternative management techniques used by hedge funds include a wide spectrum of different strategies. Hedge funds seek to position themselves in niche markets in which numerous and profitable inefficiencies are open to exploitation and where they can apply their own investment style. There are as many strategies and styles as there are niches and management specialisations. In addition, players in this industry are continually exploring new niches to exploit in order to make significant returns and maintain a competitive edge. It is therefore difficult to give a standard definition for each strategy. We can, however, distinguish broad «families» of strategies sub-divided in turn into different styles.
The major «families» of alternative strategies:
Also known as Global Macro or CTA’s (Commodities Trading Advisors), directional strategies are designed to profit from major trends that emerge in the financial markets. Managers use their expertise in macroeconomic and/or technical analysis to anticipate or track the emergence of such major movements. These strategies are implemented in all financial markets but, in particular, in the futures and currency markets, since these are the largest and most liquid. Such strategies are capable of producing impressive returns. However, these returns are very volatile, because fund managers generally take long-term views and are thus at the mercy of short-term market movements.
Long/Short strategies may be considered as the origin of the hedge fund industry. The first hedge fund managers, including Alfred W. Jones, began using this type of investment technique back in the 1950s. They combine «long» investments, i.e. investments in stocks thought to be undervalued and set to rise, and «short» positions, i.e. investments in stocks thought to be overvalued and hence due to fall, in the hope of adding value whichever way the market moves. Thus, the aim of these strategies is to profit from rising and falling share prices. Such strategies have variable volatility depending on the style employed and each manager’s exposure to the markets in question.
Managers in this category focus on the discrepancies that exist between prices for certain financial assets in different markets. When the value of an asset deviates in an untypical way from a relative value or a theoretical price, an arbitrage opportunity is created, since the price of the asset should eventually converge towards its equilibrium point. The Arbitrage or «relative value» strategies family has the largest number of sub-styles. They generally display a «neutral» (i.e. zero) exposure to the markets. Arbitrage opportunities are created by over-reactions on the part of market participants and by their different expectations and use of financial assets. These strategies are mainly applied to debt instruments such as bonds and Treasury bills. The best known arbitrage strategies are: convertible bond arbitrage, arbitrage between securities issued by the same company (e.g. between senior debt and subordinated debt), and statistical arbitrage. Arbitrage strategies aim to produce steady returns with low levels of volatility.
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