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LM1 Hedge Fund Strategies 2024 Level III Notes © IFT. All rights reserved 1 LM1 Hedge Fund Strategies 1. Introduction and Classification of Hedge Fund Strategies...............................................................3 Classification of Hedge Funds and Strategies.......................................................................................3 2. Equity Strategies: Long/Short Equity ......................................................................................................5 Long/Short Equity ..........................................................................................................................................5 3. Equity Strategies: Dedicated Short Selling and Short-Biased.........................................................7 4. Equity Strategies: Equity Market Neutral...............................................................................................9 5. Event-Driven Strategies: Merger Arbirage.......................................................................................... 11 Merger Arbitrage.......................................................................................................................................... 11 6. Event-Driven Strategies: Distressed Securities ................................................................................. 13 7. Relative Value Strategies: Fixed Income Arbitrage.......................................................................... 16 Fixed-Income Arbitrage............................................................................................................................. 16 8. Relative Value Strategies: Convertible Bond Arbitrage.................................................................. 18 9. Opportunistic Strategies: Global Macro Strategies .......................................................................... 20 Global Macro Strategies ............................................................................................................................. 21 10. Opportunistic Strategies: Managed Futures..................................................................................... 22 11. Specialist Strategies................................................................................................................................... 24 Volatility Trading.......................................................................................................................................... 24 Reinsurance/Life Settlements................................................................................................................. 26 12. Multi-Manager Strategies ........................................................................................................................ 28 Fund-of-Funds ............................................................................................................................................... 28 Multi-Strategy Hedge Funds..................................................................................................................... 31 13. Analysis of Hedge Fund Strategies using a Conditional Factor Risk Model......................... 32 Conditional Factor Risk Model................................................................................................................ 33 14. Evaluating Equity Hedge Fund Strategies: Application............................................................... 35 15. Evaluating Multi-Manager Hedge Fund Strategies: Application .............................................. 39 16. Portfolio Contribution of Hedge Fund Strategies........................................................................... 42 Performance Contribution to a 60/40 Portfolio .............................................................................. 42 Risk Metrics .................................................................................................................................................... 44 Summary ............................................................................................................................................................... 47
LM1 Hedge Fund Strategies 2024 Level III Notes © IFT. All rights reserved 2 This document should be read in conjunction with the corresponding reading in the 2024 Level III CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM1 Hedge Fund Strategies 2024 Level III Notes © IFT. All rights reserved 3 1. Introduction and Classification of Hedge Fund Strategies Hedge funds are an important sub-set of alternative investments. They tend to attract the best investment talent; investors can access this talent by investing in hedge funds. Many hedge funds claim to offer superior returns, especially when the rest of the market is underperforming. Hedge funds have a low correlation with traditional asset classes such as stocks and bonds. Therefore, they can provide diversification benefits when added to a portfolio comprising traditional asset classes. However, the superior returns and diversification benefits of hedge funds come at a high cost. Hedge funds have high fees, complex offering documentation, and often lack full underlying investment transparency/attribution. Different hedge fund managers use different strategies which have different risk profiles. Typically, hedge fund investing requires a long commitment, and there are limited redemption options available. Over the last decade, liquid alternatives (liquid alts) have been introduced – which are based on an ETF structure and invest in various hedge fund-like strategies. They are meant to provide liquidity and access to hedge funds for average investors. However, liquid alts have underperformed similar strategy hedge funds; which suggests that perhaps the high performance of traditional hedge funds is due to their illiquidity. This reading covers the investment characteristics of the major categories of hedge fund strategies. Section 1 discusses ways to classify hedge fund strategies. Sections 2 to 12 cover the following six hedge fund strategies: • equity-related • event-driven • relative value • opportunistic • specialist • multi-manager strategies Sections 13 to 15 cover the analysis of hedge fund strategies. Finally, section 16 evaluates the contributions of each hedge fund strategy to the return and risk profile of a traditional portfolio of stocks and bonds. Classification of Hedge Funds and Strategies Important characteristics of hedge funds include: • Legal/regulatory requirements: The legal/regulatory requirements for hedge funds vary across countries. From an investor’s perspective, regulations in most countries limit access to hedge funds to sophisticated investors with a minimum income or net-worth requirement. Small investors are generally discouraged from investing in hedge funds.
LM1 Hedge Fund Strategies 2024 Level III Notes © IFT. All rights reserved 4 From the fund manager’s perspective, hedge funds are far less regulated as compared to other investment vehicles such as mutual funds. • Flexible mandates: Due to low legal and regulatory constraints, hedge funds have very flexible mandates. They can invest in a broad universe of asset classes and securities. They can use leverage, short positions, and derivatives. • Large investment universe: As discussed above, due to low regulatory constraints and flexible mandates, hedge funds have a large investment universe. • Aggressive investment styles: As compared to traditional investment funds, hedge funds can pursue aggressive strategies that are relatively riskier, such as significant shorting, concentrated positions in foreign and domestic securities, etc. • Relatively liberal use of leverage: To generate significant returns, hedge funds use significant leverage. • Hedge fund liquidity constraints: Most hedge funds have lock-up periods. This allows hedge-funds to pursue relatively illiquid strategies. • Relatively high fee structures: Hedge funds have relatively high fee structures. Typically, the fee structure includes a management fee of 1% or more of AUM and an incentive fee of 10% - 20% of annual returns. Hedge fund strategies are generally classified based on a combination of: 1. Instrument in which the manager invests 2. Trading philosophy 3. Types of risks the manager assumes Some of the leading hedge fund index providers are Hedge Fund Research, Inc.; Lipper TASS; Morningstar Hedge/CISDM; Eurekahedge; and Credit Suisse. Each provider classifies hedge fund strategies differently. The curriculum classifies hedge fund strategies into the following six categories and sub- categories. Each strategy is covered in detail in the subsequent sections. 1. Equity strategies: focus on the equity markets. • Long/short equity • Dedicated short bias • Equity market neutral 2. Event-driven strategies: focus on corporate events, such as mergers and acquisitions, bankruptcy, etc. • Merger arbitrage • Distressed securities 3. Relative value strategies: focus on the relative valuation between two or more securities. • Fixed-income arbitrage • Convertible bond arbitrage