Hedge Fund Strategies
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Thomas Kirchner is The Deal Sleuth

Hedge Fund Strategies
© 2008 by Thomas Kirchner
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The e-book has been made available for informational purposes only. It contains information
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Acknowledgments: The idea for this e-book is Ron Charnock’s, whom I also thank for
helping with its design. Many thanks to Anthony Von Mickle for giving me the opportunity
to present its content at an event of “The Investment Forum LLC”.
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Let's start with some name dropping.
This is John Paulson, who runs a hedge fund firm by the name of –
you guessed it – Paulson & Co. His claim to fame is his pay check for
2007: he is reported to have made $3.7 billion. That's “billion” with a
“b”.
He earned this payout by making a profit of $15 billion for his
investors last year. His flagship fund generated a return of 599%.
No wonder he looks happy.
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This is George Soros, who runs a hedge fund firm by the name of
Soros Fund Management.
He looks unhappy.
Maybe because Paulson stole the #1 spot in paychecks for last year.
Soros made $800 million less than Paulson, only $2.9 billion.
But no worries. Soros became famous in 1992 when he broke the
bank of England, netting him $1 billion.
A billion dollars was considered a lot of money at the
time.
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Hedge Fund Strategies
This is Christopher Hohn.
He is a relative pauper, apparently worth only a few $100 million. He
gave away most of his money to a children charity.
What makes him join the list of billionaires is not his income, but rather
his losses.
The hedge fund he manages reportedly lost $1 billion in a single month,
June 2008. The size of his hedge fund went from $8 billion to $7 billion.
Let's make clear that Hohn is a very smart guy. He graduated 5th in his
class from Harvard Business School. But even smart people can
generate spectacular losses. Just remember Long Term Capital
Management. Not one, but two Nobel laureates ran this hedge fund that
collapsed in 1998.
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HEDGE FUNDS ARE “ALTERNATIVE” INVESTMENT STRATEGIES
Hedge funds are generally associated with big amounts of money, big checks, and big bets. Hedge funds
are considered evil unregulated speculators who push stocks to highs, or crash them.
In this e-book, we will take a different look at hedge funds. One of the best ways to look at them is to
examine the investment strategies that they employ.
Chart 1 – Source Most readers will be familiar with the style boxes. You have probably seen this in
you 401(k) plan's literature or elsewhere. This is how investors traditionally have
viewed the market. It is a very simple concept: You can invest in large, medium or
small companies that either are cheap, grow quickly or are somewhere in between.
It is not a very sophisticated approach to investing. It goes back to research done a
good two decades ago by two academics and has not changed ever since.
Arguably, the markets have changed.
Hedge funds take a radically different view of investing. Rather than focusing on characteristics of the
companies, they have completely different strategies, many of which are quite sophisticated. The chart
below shows a classification of different hedge fund strategies. Unlike the style boxes of traditional
investing, there is no generally accepted standard classification for hedge fund strategies.
Chart 2 – Fuss, Kaiser and
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HEDGE FUNDS HAVE THREE DIFFERENT STYLES AND STRATEGIES
There are three different styles: arbitrage, event-driven and directional. Different strategies are part of each
style.
Arbitrage Benefits from price discrepancies of otherwise similar securities
Equity Market Neutral - Buy one stock and sell short another. For example, sell
short an overvalued stock and buy an undervalued one
Fixed-Income- Buy high yielding bonds and sell short similar bonds with low yields
Convertible Arbitrage - Hedge convertible bonds with stock
Event-Driven Takes advantage of mal pricing of corporate events
Merger Arbitrage - Capture difference between market price and acquisition price
Distressed Securities - Buy bonds of companies in bankruptcy and take ownership
when a firm emerges from bankruptcy
Special Situations - The above plus investments in other corporate events such as
liquidations or spin-offs
Directional Trade ups and downs in the market
Equity Long-Short - Go long or short stocks
Managed Futures - Invest in commodities
Global Macro - Buy or sell short any asset anywhere in the world based on where
the manager thinks the market is heading
Although these strategies are usually referred to as “hedge fund” strategies, they are not only used by
hedge funds. A better term is “alternative” investment strategies, to distinguish them from the traditional
investments that most 401(k) investors are limited to.
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THE EVOLUTION OF HEDGE FUND STYLES OVER TIME
If we look at which strategies most hedge funds were invested in in 1990, we see that (Global) Macro
accounted for almost three quarters of all hedge fund assets. If you recall, Global Macro is a directional
strategy where the manager tries to anticipate the movement of different markets. The perception that
we have today about hedge funds goes back to the early 1990s, when big trades on market direction
were what most hedge funds did all day long.
Chart
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Hedge Fund Strategies
The situation has changed significantly since then. In early 2007, (Global) Macro accounted for just
under 5% of all hedge fund assets. Hedge funds are now much more evenly spread out among the
different strategies.
Chart
Source of both charts: HSBC Private
Hedge funds are now much more evenly spread out among
all strategies
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WHAT MAKES HEDGE FUNDS DIFFERENT
If you ask a hedge fund manager about what they do, they will tell you their
strategy, performance and one other aspect that sets them apart from traditional
managers: they depend little on the overall direction of the market. In financial
parlance, they have a low correlation to the market.
Most investors focus most and foremost on the return of an investment. However,
1987-2006 an increasing number of
Average 1987-2006 investors are looking to
Annual Standard find investments that not
Style Return Deviation only have a decent
Market Neutral Index 7.95 4.86 return, but also one that
Fixed Income Index 13.79 22.65
is independent of the
Convertible Arbitrage Index 9.66 7.35
market as a whole. One
Event Driven Index 16.02 12.46
that zigs when the market
Merger Arbitrage Index 11.29 9.42
Distressed Index 16.52 12.38 zags. The reason is that
Opportunistic Index 14.66 10.66 such investments help to
Long/Short Equity Index 13.64 9.01 stabilize the overall
Global/Macro Index 14.84 16.5 portfolio and reduce the
Hennessee Hedge Fund Index 13.59 9.28 gyrations in the net worth
S&P 500 9.24 16.15 that investors experience
DJIA 9.87 13.96 whenever the market goes
Russell 2000 9.5 18.19 through a rough period.
NASDAQ 10.16 30.59
Lehman Brothers Int. Gov. Corp.
Bond Index
The table shows hedge
7.34 5.24
fund returns for the
period 1987-2006 collected by Hennessee. There are many firms that collect
hedge fund data, and each has slightly different numbers; however, they all show
the same effect that we will see in the Hennessee data.
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Hedge Fund Strategies
A convenient way to visualize the table is a risk/return chart. The best place to be is the top left of the
diagram: produce a high return with little risk. This is the holy grail of investing, and as the chart shows,
nobody has achieved it yet.
Chart
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HEDGE FUND SIZE DOES MATTER …
Risk/return is just one of the tradeoffs of investing, For hedge funds, there is another dimension that
complicates the analysis. Larger hedge funds tend to have a lower performance than smaller ones.
Chart
The chart shows that large funds with more than $1 billion is assets have on average a return that
is 2% lower than that of smaller funds with just a few million dollars in assets. This effect does not
normally appear in traditional or index investments. In traditional investments, markets are very large and
there is almost no practical limit to how much an investors can allocate. For alternative strategies,
however, there is often a limit to how much can be invested in the most profitable opportunities. Or
conversely, a limited number of very profitable investments is available and additional assets must be
invested in lower yielding opportunities.
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HEDGE FUNDS ARE NOT FOR EVERYBODY
So why isn't everybody in hedge funds?
There are many restrictions that keep most investors out.
Most hedge funds are private partnerships that are not registered with the SEC and can not be offered to
the public. The SEC limits the sale of such risky structures to those who can afford to lose their entire
investment. That means that you need at least $1 million in liquid assets, or an income of $300,000, if you
want to invest. (The SEC is looking at raising these limits)
Another restriction comes from the high minimum investment that these funds require. Often, you have to
invest at least $1 million. So even if you meet the SEC requirements, you would still have to put all of your
assets at risk just to get in. That hardly would be prudent.
Finally, many investors are put off by the high fees charged by hedge fund managers. The typical fee
structure consists of a 2% management fee, plus 20% of profits. We will see an example with numbers in a
moment. That compares to average mutual fund fees of less than 1.5%, and mutual funds do not normally
take a percentage of profits.
Therefore, hedge funds are beyond the reach of most investors.
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Hedge Fund Strategies
BUT WAIT – WALL STREET’S SOLUTION
Where there are fees, there is an investment banker.
Wall Street firms have developed a solution that makes hedge funds a little more accessible to the public
through so-called funds of hedge funds. A fund of hedge funds is simply another fund that collects smaller
investments from a large number of investors and then invests into hedge funds. By spreading the
minimum investment over more investors, each can make a smaller investment than what a typical hedge
fund would require. Many funds of hedge funds have minimum investments of $50,000 or less.
The drawback of funds of hedge funds is that they will charge additional fees. We mentioned earlier
that hedge funds charge a 2% management fee and 20% of profits. A fund of hedge funds will charge an
?
additional 1% fee and 10% of profits.
A simple calculation shows that with so many fees, little is left for investors.
1. Hedge Fund Fees
Return on Strategy 15%
Management fee (2%)
13%
Performance fee (20% of 13%) (2.6%)
Net performance 10.4%
2. Fund of Funds Fees
Return on Hedge fund 10.4%
Management fee (1%)
9.4%
Performance fee (10% of 9.4%) (0.94%)
Net performance to investor 8.46%
This example assumes that a hedge fund manager generates a 15% return, before fees. If you invest
directly into the hedge fund, you will see a net return after fees of 10.4%. However, if you invest
through a fund of hedge funds, you net performance will be just under 8.5%.
Therefore, funds of hedge funds are probably not a good way to keep up with the Jones'. Or Paulson's.
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MUTUAL FUNDS WITH HEDGE FUND STRATEGIES
Fortunately, there are simpler solutions. Whenever there is a problem, someone will solve it.
Mutual funds have been slow to fill the gap, but there is an increasing number of mutual funds that use
alternative (hedge fund) strategies. The following list provides a few examples of fund ticker symbols for
each of the strategies that were discussed earlier.
Arbitrage
Equity Market Neutral BPTRX
Fixed-Income MWSTX
Convertible Arbitrage CVSIX
Event Driven
Merger Arbitrage ARBFX
Distressed Securities FMRAX
Event-Driven PAEDX
Directional Strategies
Equity Long-Short ALPHX
Managed Futures PCRDX/SuperFund
Macro HSGFX
For most investors, these funds are the best way to participate in
alternative strategies without the drawbacks of hedge funds. All of the
funds shown above are regulated and fully transparent.
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LOOKING AT EVENT-DRIVEN STRATEGIES
We will now change gears and discuss one of the alternative strategies that the author is familiar with from
his day to day work in more detail. We will focus on activist investing and merger arbitrage.
The diagram below shows a hypothetical company's stock price as it goes from not performing very well to
being bought out.
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GRAPH POINT 1 When a company's stock price does not so well, it become a value investment.
This means that it is cheap relative to earnings. The problem with value
investments is that sometimes, value stocks remain value forever. This is
called a “value trap.”
GRAPH POINT 2 Fortunately, in many instances, the board of directors of a cheap stock will
decide that they will sell the firm rather than having a cheap stock. When they
plan to do so, they will issue a press release that can sound cryptic, such as
“we are searching for strategies alternatives,” or “we have established a
special committee of the board.” In other instances, and activist investor will
get involved. These are investors who try to increase the stock price of a value
stock, often by getting representation of the board with the goal of getting the
firm to sell itself. In either case, the stock usually makes a small jump.
GRAPH POINT 3 Eventually, if there is an actual merger announces, the stock will make a big
jump on the day of the announcement.
GRAPH POINT 4 At this point, the stock becomes a merger arbitrage investment.
Merger arbitrage tries to capture the small difference between the buyout
price of a stock, and the price at which it is trading just before the
buyout.
Once a merger is announced, the stock makes a big jump. However, it does not rise to the price of the
buyout right away. As long as there is still the risk that the merger does not happen, it will trade below the
buyout price. A merger arbitrage investor will purchase the stock shortly after the announcement, and hold it
until the buyout is complete. The difference between the buyout price that the arbitrageur receives and the
price paid is the profit from the strategy. This profit is generally small in absolute terms. However, it is
earned over a relative short time, so that the annualized return can be very attractive.
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WHAT’S MERGER ARBITRAGE?
Merger arbitrage tries to capture the small difference between the buyout price of a stock, and the price
at which it is trading just before the buyout.
Arbitrage
Profit
Price First Day
Jump
Merger Stock Merger
Announcement Purchase Closes
Time
Once a merger is announced, the stock makes a big jump. However, it does not rise to the price of the
buyout right away. As long as there is still the risk that the merger does not happen, it will trade below
the buyout price. A merger arbitrage investor will purchase the stock shortly after the announcement,
and hold it until the buyout is complete. The difference between the buyout price that the arbitrageur
receives and the price paid is the profit from the strategy. This profit is generally small in absolute
terms. However, it is earned over a relative short time, so that the annualized return can be very
attractive.
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MERGER ARBITRAGE IS A STRATEGY WITH LOW VOLITILITY
One of the important characteristics of alternative strategies is their low
dependence on the overall direction of stock prices. The low volatility of the
strategy is best illustrated by a couple of
examples. First, we have a chart of the daily
price changes of Admiralty Bancorp for a
period of a little over one year. It can be seen
very clearly when the merger announcement
was made. Prior to the merger
announcement, Admiralty Bancorp's stock
was fluctuating widely from day to day. Once
the merger had been announced, there were
almost no fluctuations.
This effect can also be seen
in a price chart. Before Mars
made its acquisition of
Wrigley public, the stock of
Wrigley experienced large
ups and downs. After the
announcement, it moved in
a very narrow range.
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Aggregate monthly returns of merger arbitrage funds tracked by Hennessee confirm that volatility of these
funds is lower than that of other investments. The merger arbitrage funds fluctuate much less than the S&P
500 or bonds. They are also positive in more months
10.00%
5.00%
0.00%
Return
-5.00%
-10.00%
-15.00%
Jan-93
May-93
Sep-93
Jan-94
May-94
Sep-94
Jan-95
May-95
Sep-95
Jan-96
May-96
Sep-96
Jan-97
May-97
Sep-97
Jan-98
May-98
Sep-98
Jan-99
May-99
Sep-99
Jan-00
May-00
Sep-00
Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
S&P500 Bonds Hennessee Merger Arbitrage Index
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HERE’S HOW IT MIGHT LOOK
To see how a portfolio behaves when we add merger arbitrage to it, we constructed two portfolios: a
traditional one that consists only of an S&P 500 and a bond index fund, and an alternative one that
includes also the Pennsylvania Avenue Event-Driven Fund. For the S&P, we use the index fund with the
ticker symbol SPY, and for the bond fund, the index fund with ticker AGG. Both are exchange traded
funds, abbreviated “ETF”.
Alternative Strategy Portfolio
SPY (S&P 500 Index Fund
AGG (Lehman Bond Index Fund)
PAEDX (Penn Ave Event-Driven Fund)
Traditional Strategy Portfolio
SPY (S&P 500 Index Fund
AGG (Lehman Bond Index Fund)
This chart shows different combinations of assets of the two portfolios. For example, the traditional
portfolio consists primarily of the bond fund for low levels of risk. As we increase the allocation of the
S&P 500 index fund, its risk increases, and so does its return. The lower line shows different levels of
risk and return that can be achieved by varying the ratio of stocks and bonds in the traditional portfolio.
The upper line is constructed by the same principle. It depicts different levels of risk and return that
can be achieved by changing the ratio of the S&P, the bond fund and the event-driven fund. The main
point of this diagram is to show that at a given level of risk, say 1%, the alternative portfolio will
achieve a much higher return than the traditional portfolio. It should be noted that weekly data was
used to construct this chart.
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WHAT CAN GO WRONG?
Each merger is different, and an arbitrageur must examine each carefully to understand where the risks
lie. Most recently, the biggest risk has been financing. Many buyers have seen their financing withdrawn
as the credit markets have deteriorated.
Anti-trust risk is present mainly in large mergers. However, anti-trust enforcement has been relatively lax
over the last few years, and has resulted in few transactions being held up.
Shareholder opposition can derail a merger because in most cases, shareholders must vote before the
transaction can go ahead. Sometimes, large investors do not agree with management's strategy and will
seek to block the transaction. They are not often successful but can wreck havoc on an arbitrageur.
Political risk is a relatively new phenomenon that came to the public's consciousness when the
acquisition of a number of ports by Dubai World was blocked for purely political reasons.
Each merger is different … examine each carefully to
understand where the risks lie
Material Adverse Change is the flavor of the day. As the economy deteriorates, buyers sometimes try to
get out of mergers well after they have signed the agreement. The merger agreements contain a clause
that defines under what circumstances changes in the business or economic conditions justify a
termination of the merger.
Fraud fortunately happens rarely, but Enron investors will remember that Dynegy terminated its
acquisition of Enron when the full scale of misconduct at Enron became apparent.
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SO WHAT’S NEXT …
The recent merger boom came to an abrupt end when the credit crisis set in, and numerous transactions
have since failed when banks withdrew their financing commitments. Banks were more concerned with
their survival than maintaining long-term relationships with their customers. As a result, even merger
contracts with solid legal foundations turned out to be worthless. Private equity funds acquire companies
mainly with borrowed funds, and as they are now unable to borrow, many have withdrawn.
Fortunately, the slack has been picked up by strategic acquirers. Those are companies that buy other
companies. In the last few years, they had been locked out of mergers by the ability of private equity funds
to obtain cheap loans. Now, they are buying each other again. We are also seeing an increase in the
acquisition of U.S. companies by foreign buyers. Much of this has to do with the low value of the dollar,
which makes it very inexpensive for foreigners to buy firms here.
Overall, there is plenty of activity that keeps merger arbitrageurs busy.
Adding alternative strategies to your portfolio should increase its
return and lower its risk.
However, before you start investing, a few words of caution are in order:
You may already have indirect exposure to alternative strategies if you participate in a pension plan. Many
pension trustees have begun investing heavily in hedge funds recently. If you add some to your own
portfolio, you may inadvertently double up.
Diversify! Only invest what you can afford to lose.
The moral is that these types of investments are not for everyone. You should consult a financial adviser
before investing.
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Hedge Fund Strategies
info
ABOUT THE AUTHOR
Thomas F. Kirchner, CFA is the founder and manager of the Pennsylvania Avenue Funds and
its investment adviser, Pennsylvania Avenue Advisers LLC. He is responsible for the day-to-day
management of the Pennsylvania Avenue Event-Driven Fund (PAEDX). He also serves as the
President and a Trustee of the Fund. From 1996 to 1999 he worked as a Bond Trader and
Financial Engineer for Banque Nationale de Paris S.A. From 1999 to 2004, he was retained by
Fannie Mae, a mortgage firm, as a Financial Engineer. Mr. Kirchner holds a B.Sc. from King's
College, University of London, a Diplôme from the Institut d'Etudes Politiques de Paris, and an
MBA from the University of Chicago Graduate School of Business. He has earned the right to
use the Chartered Financial Analyst designation. He writes a blog about mergers that receive
little press coverage at The Deal Sleuth http://thedealsleuth.wordpress.com/
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