Relative Value

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Relative value hedge strategies include market-neutral equity, convertible bond arbitrage, and fixed-income arbitrage. Relative value is one of the least homogeneous groupings of hedge strategies. It generally relates to nondirectional strategies that attempt to capture a pending convergence in valuation between securities. As such, the securities positions typically are paired and therefore tend to have a natural hedge in place. For instance, a relative value position might include a long position in one security paired with a short position in another security with the securities being similar in asset class but disparate in valuation. A relative value arbitrage might be conducted among different voting classes of securities issued by a common public entity. Furthermore, relative value strategies may use securities with different seniority from the same or different issuers and attempt to capture arbitrage spreads among them, sometimes with the assistance of derivatives on the securities. This endeavor also is called capital structure arbitrage. Typically, relative value strategies are sensitive to the absolute level of short-term interest rates, to the extent that the risk-free rate is the starting point from which the expected return from a relative value trade is constructed. A hedge fund will not seek to capture a discrepancy in valuation between two securities unless that discrepancy incorporates a spread above the risk-free rate of return. Another feature of relative value strategies that particularly differentiates them from event-driven strategies is their often ill-defined terminal points. The spread between two securities that is being captured from a relative value perspective does not have to close during any predetermined time frame. Granted, a hedge fund manager would like the spread to have as short a duration as possible, but typically there is nothing inherent in these trades that defines duration. Furthermore, some relative value strategies are perpetual in nature, where it is not so much the spread in valuation between securities that is being captured on a completed basis as it is the volatility of the spread that is being captured through dynamic changes to the amount of exposure to the short or long portion of the securities involved in the trade.

Market-Neutral Equity Market-neutral equity is a natural extension of long-only equity investment, and could very well be included as a substrategy of long/short equity. This substrategy represents the matching of an equal amount of long exposure to short exposure with no material positive or negative directionality to the equity market. While simple in concept, there are pitfalls in the execution of this approach that can render it not to be market neutral in certain environments. Beyond having an equal dollar amount of long and short equity exposure, portfolios in this area must ensure market neutrality as it also pertains to sectors, styles, and betas of the long versus the short portions of the portfolio. A near-zero net exposure implies little if any directionality or correlation to equity markets. However, this is not always the case if, for example, the market-neutral fund is constructed without regard to the individual betas of its underlying securities. Although a fund may be constructed equally long and short from a dollar perspective, the betas to the equity market of the longs may on average be smaller than the betas of the equities that have been sold short. Beta neutrality is an important element of ensuring market neutrality, particularly during moments of sharp market volatility when the movements in higher-beta stocks are greater than the movements in lower-beta stocks. In some cases, it may be that beta, neutrality requires being slightly non-dollar neutral. In addition to ensuring beta neutrality, market-neutral funds must ensure industry, geography, and style neutrality. Industry neutrality indicates that on a beta-adjusted basis the portfolio is long an equal amount of corporate issuers in one industry as it is short the securities of issuers in the same industry. Geographic neutrality is the discipline of being zero net exposed to any one country or market, thereby indicating the state of being long on a beta-adjusted basis an equal amount as short in those areas. Style neutrality measures the state of having neutral exposure on a beta-adjusted basis to growth; value; and small-, mid-, and large-capitalization stocks, the descriptions of which sometimes change over time as the size or characterization of securities is altered.

If one assumes that market-neutral investing has no beta to the equity market, then in a one-factor regression model the strategy should have no source of return other than a unique return, or alpha. Of course, this disregards the potential for any other fundamental factor betas to exist, such as elements of the fixed-income market (see Chapter 11). Additionally, volatility of the markets in which market-neutral equity funds trade also can have an impact on returns. Although perfectly market-neutral portfolios should not be affected either by declining or rising equity markets, short-term movements in individual securities prices enable these funds to capture discrepancies in valuation that they have identified.

The basic qualitative factors that drive returns for market-neutral equity funds relate to security selection, portfolio risk management, trade execution, and expense management. Security selection is perhaps the most important aspect of this investment style. A variation of market-neutral equity is the trading of discrete pairs of securities in more concentrated portfolios, rather than building a portfolio of a larger number of securities that may span an index. The success in security selection is even more relevant and apparent in pairs trading. Approaches to security selection in market-neutral equity include fundamental, quantitative, and technical. The ability to be successful using any of these approaches is critical for generating returns in a portfolio that is beta neutral. This is important since the market-neutral environment does not benefit from the underlying directional movement in the equity market.

Portfolio risk management can be an area where market-neutral investing is vulnerabe to failure. Maintaining a neutral balance through portfolio risk management is a focal point for success. Appropriate diagnostics must be established and monitored to ensure neutrality of a market-neutral portfolio's exposures to beta, sector, and style, for example. These diagnostic systems should be overseen by someone with judgment and perspective, such that new risks that are security specific or systemic in nature can be identified and neutralized. Examples of security-specific risks are market capitalization or industry creep that can occur as issuers gain or decline in value or change their industry sensitivity through mergers or divestitures. An example of systemic risk is the notion that some market-neutral funds have a quality bias, if they purchase securities with strong fundamental considerations and sell short those with relatively weaker fundamentals. These market-neutral funds may be vulnerable to certain rallies in the equity market that favor lower-quality, higher-beta equities at the expense of higher-quality, lower-beta equities. Some of this risk can be managed through the control of beta neutrality on a dynamic basis.

Trade execution and expenses represent a frictional cost to market-neutral equity investing that must be minimized. Assuming that the approaches to security selection and portfolio risk management to ensure market neutrality are equal among market-neutral equity funds, which they are not, a differentiator that affects relative performance at the margin is trading execution and related cost management. Trade execution seeks to minimize market price impact and commission expense. Market-neutral equity funds that are based on fundamental security selection typically have higher trading expenses than those based on quantitative security selection. A fundamental approach often has a reliance on investment research that carries with it higher commission expenses, while quantitative and technical approaches are either not associated with premium commissions charged by brokers or are executed through electronic systems that bypass full-service brokerage firms. The fundamental security selection approach may actually benefit through net investment performance in spite of higher commissions, if quality research enables the fund to conduct its security selection in a more effective manner. However, in the quantitative realm, brokerage is less well differentiated, except for speed and perhaps volume, and therefore is driven more by price considerations.

Investors find attraction in market-neutral equity investing owing to the strategy's consistent performance, low correlation to the equity market, and low volatility. The allure of market-neutral equity is its promise to generate bondlike returns with more stable standard deviation and less symmetry of these returns than is the case for bonds, with their sensitivity to interest rates. A basic risk for investors regarding market-neutral equity is in the event that the premise of neutrality for the strategy fails, and it becomes directional to the underlying equity market. Such a potential failure could manifest itself as positive or negative correlation to the equity markets. Unintended correlation may have a positive outcome (positive correlation to a rising equity market or negative correlation to a falling market) or more likely a negative outcome (positive correlation to a falling market or negative correlation to a rising market). Indeed, negative correlation to a rising equity market was the case for many market-neutral equity funds during the last part of the twentieth century, when market neutrality became unhinged by a value-style dependency. In the environment of the late 1990s, a rising equity market driven by low-quality, highly speculative growth stocks, which occurred over a sustained period, was a mismatch for many market-neutral equity funds that tended to be short these securities. In the evolution of market-neutral investing, this experience gave way to the inclusion of style and beta neutrality in portfolio construction rather than the prior somewhat sole focus on dollar neutrality.

Convertible Bond Arbitrage There are at least three types of convertible bond strategies in which hedge funds engage: volatility trading, credit-oriented investments, and special situations that can include private investment in public entities (PIPEs) that are structured as convertible bonds. Each of these approaches to owning and hedging convertible bonds has different determinants of return and risk. Furthermore, each possesses different features of desirability and risk for investors. Some of these traits overlap other types of hedge strategies as well as other types of alternative investments. These commonalities are at the root of the need for more accurate measurement of the components of return and risk that can be determined through factor analysis. However, some of the factor sensitivities for convertible bond arbitrage are more qualitative than quantitative. These environmental considerations can hold equal importance as quantitative regressable factors. Although qualitative factors are difficult to specifically transform into metrics that can be used in algorithms, they are important to measure by investors when evaluating the desirability of these strategies at any point in time.

Volatility Trading The classic approach to convertible bond arbitrage relates to volatility trading. In this strategy, a hedge fund is long a convertible bond and short a position in the issuer's common equity. The amount of short relative to the bond position relates to the degree to which the hedge fund wishes to hedge the convertible bond and the common stock into which it is convertible. In this strategy the investor receives several sources of income and capital appreciation, including: a current coupon payment from the convertible bond, the potential for appreciation in the price of the bond, and the potential for depreciation in the short equity position. There are also certain expenses, such as the cost of financing leverage associated with the strategy as well as the cost for paying dividends on short common stock positions. An appreciation in the price of the bond might be stimulated by a rise in the common stock price, since the bond is convertible into common stock, or by a decline in interest rates, which should benefit the bond as its yield becomes relatively attractive and its price adjusts upward. The hedge in this configuration of securities is a short position in the common stock. It also is where much of the return from the strategy is generated as well as where the volatility moniker is derived. A potential decline in the common stock may occur on an incidental basis. When it does occur, a portfolio manager using this strategy should benefit from the short position in common stock, while the convertible bond should not decline as much, because its par value and yield provide a floor to its price. In contrast, if the stock price rises, then the short position should generate a loss. However, this loss should be reduced by the long position in the convertible bond, which may rise based on the value of the underlying common stock into which it is convertible. During these gyrations, the portfolio manager may adjust the amount of short common stock to reflect changes in the underlying securities prices, thereby adjusting the hedge ratio. The more volatile a stock price on a short-term basis, the more there may be an opportunity in this strategy to capture return. Thus, short-term volatility is a key driver of returns for this approach. As such, since volatility usually is associated with a decline in stock prices, a convertible bond arbitrage strategy built on volatility trading holds attraction to investors because of its natural diversification benefit when added to assets that have more directionality with the equity market. The strategy also has had a historical tendency to generate consistent returns in most environments. A risk for investors in this strategy is that it generally requires leverage, which can exacerbate losses when they do occur. An additional risk is that hedge funds operating in this area tend to be correlated and tend to dominate the ownership of all convertible bonds. If a problem develops for one sizable hedge fund, it can impact the liquidity of and market price for all convertible bonds and therefore all hedge funds in the strategy.

There are myriad other influences that impact the return-enhancing environment for the convertible bond volatility trading segment. For instance, the availability of convertible bonds in the marketplace is a key consideration, because this strategy has finite capacity as defined by the market size of all convertible bonds. The level of convertible bond new issuance is an important factor that determines the supply of available bonds. An increasingly chronic problem for this strategy is the ability to generate consistently high returns, because of limited capacity and more capital entering the strategy than it is capable of handling. Another aspect of this problem is that the crowding of capital into the strategy can produce undesirable volatility. Therefore, the amount of capital and leverage devoted to the convertible arbitrage strategy relative to the market for convertible bonds is another factor to evaluate.

Credit Trading The credit trading aspect of convertible bond arbitrage is similar to the distressed debt strategy in the event-driven category, since it largely depends on credit research. As such, the factor drivers of return and risk have some identical parallels with the distressed credit area, and many investors may choose to consider credit trading of convertible bonds as a dimension of that strategy. The essence of trading convertible bonds with a credit approach is the purchase of bonds hedged through the short sale of equity or the purchase of credit default swap protection. However, the money-making aspect of this strategy is not as focused on the volatility of the underlying stock price as is the case for volatility trading of convertible bonds. Rather, it is focused on the correct credit analysis of the bonds. The bonds under consideration may be trading at a discount based on the market's perception of the issuer's low credit rating or prospects. Astute credit research may identify a discrepancy between the true credit merit of an issue versus the market's pricing of the bond. In this way, a potential profit is captured through the purchase of a convertible bond with the hope that the bond price will rise as the primary source of return for the trade. A short equity position in this instance represents either a hedge in the event that the credit analysis is incorrect or an outright profit generator in the instance that an improvement in the credit outlook for the bond for some reason benefits the bondholders at the expense of the common shareholders.

The return drivers for credit trading of convertible bonds are focused on the movement in overall credit spreads across all credit instruments in the marketplace, as well as issuer-specific changes in fortune. Accurate security selection, credit research, and appraisal of convertible bond issuers are paramount for success in this strategy. Credit-driven convertible bond investing is oriented toward securities that may be near or in default, the security selection mechanics of which essentially are similar to the distressed strategy in the event-driven category. Access to bonds that may be difficult to acquire also may be a consideration. Furthermore, there can be an event aspect to the return from credit in convertible bonds. Financial restructuring, operational reorganization, potential spin-offs, and mergers and acquisitions also may have a bearing on the return from these investments. In some cases, these events improve the credit quality of convertible bonds, and in others they diminish credit quality. The prospect for these events and the environment that fosters a high or low incidence of their occurring are important contributors to return and risk in this strategy. Meanwhile, the basic appeal of the credit-oriented convertible bond strategy for investors lies in the same kind of appeal for other types of credit strategies, which is focused on absolute return through security selection-specific skill. The risk for investors is the potential for this skill to be errant, thereby leading to negative returns from security selection regardless of the movement in overall credit spreads that may positively or negatively affect the market for credit-influenced securities.

PIPEs Private investment in public equities, or PIPE transactions, often are structured as privately sold convertible bonds issued by public companies. At the time of the initial investment by purchasers of these bonds, this strategy has a long-only quality. The common stock into which the convertible bonds are convertible is initially unregistered. Hedging can occur through the short sale of peer groups that may have similar operating characteristics as the issuer of the PIPE. However, the short sale of common stock in advance of PIPE securities becoming registered is against securities regulations in the United States. The drivers of return in this strategy relate to deal flow and the discount between the PIPE securities and the price of the common equity into which they are convertible. Both of these return drivers depend on the skill of the investment manager who is securing, evaluating, and negotiating these transactions. Manager skill defines the attraction of this strategy for investors. An additional appeal of this strategy for investors is the ability to purchase public equities at a discount from their market price. However, a risk is that this discount cannot be monetized prior to a decline in the market price of the securities. Furthermore, the PIPE area has historically been fraught with regulatory issues. PIPE transactions can provide a unique source of return that is not dependent on the overall movement of the equity or bond markets. This unique source of absolute return also relates to another risk to investors in this strategy, which is the event that deal sourcing, researching, and negotiating by investment managers is not adequate and ultimately leads to returns that do not justify an investment. (For more on PIPE investments, see Chapter 7.)

Fixed-Income Arbitrage Leveraged fixed-income arbitrage is a strategy that seeks to capture perceived relative value spreads among fixed-income securities. The leverage involved in this strategy can be accomplished notionally though futures or through cash borrowings generated from brokers or through term loans and revolving credit agreements. Often, leverage is accomplished through repurchase agreements with brokerage firms, which generate cash that is used for the purchase of other higher-yielding securities. Typically, operators of this strategy identify valuation discrepancies among fixed-income securities that may be of different durations or different issuers. To capture yield differences among these securities, leverage can be 10 times or more of the equity capital invested in these funds.

The essential return drivers for this strategy are the absolute level of interest rates, the slope of the yield curve, and periodic shifts in the yield curve. Furthermore, the availability of capital and the ability to leverage invested equity is a critical aspect to ensuring the viability of these portfolios. This strategy often is associated with the basic carry trade, which is the sale of short-duration bonds and purchase of longer-duration bonds using leverage and capturing the yield differential between the securities. There are many variations on this concept, including the use of bond futures and hedging techniques that incorporate swap contracts on interest rates, credit, and currencies. However, the key return driver for the carry trade approach to fixed-income relative value investing is the slope of the yield curve. A greater slope indicates a larger interest rate spread between long- and short-duration bonds, and therefore a greater return for the strategy. A flatter yield curve warrants a lower return, owing to the smaller interest rate spread between long- and short-duration bonds. The key determinants of the slope of the yield curve can include U.S. Federal Reserve Bank monetary policy, the market demand for long-dated bonds, and the strength or weakness of the economy including the rate of inflation. The bond futures market allows for speculation regarding each of these drivers and can add speculative premiums or discounts to the market, which can marginally affect returns as well. Furthermore, the ability to borrow capital is significant for funds involved in this strategy. It is the leverage of bonds that enables the returns from this strategy to be attractive. For instance, if the interest rate spread between long- and short-dated bonds is 100 basis points, this represents a fairly unattractive return per annum. Thus, leverage is required to multiply the equity invested in these funds by investors. The narrower the interest rate spread, the greater the amount of leverage that is required to generate an attractive absolute return for investors. Tight credit conditions can stimulate a lack of lending capacity by brokers to funds that invest in this style, which can have a diminutive effect on returns from the strategy.

The appeal of this strategy for an investor is its fairly consistent performance, especially during periods of steep or flattening yield curves. When long-term interest rates are declining, the strategy benefits from yield capture and capital gains from leveraged long positions in long-duration bonds. A risk in this strategy for investors relates to a cyclical rise in interest rates, unpredicted changes in interest rates, and the early prepayment of debt securities by their issuers, which can have the effect of shortening duration and changing prices of the securities. All of these risks are exacerbated by the substantial leverage used in this strategy. Each of these risks, when manifest, can cause far greater losses than expected for this strategy. Losses in this strategy, when they occur, can be many standard deviations away from historical mean returns.

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