Hedge Fund Strategies in the Post-Crisis Era

This chapter examines the performances of various hedge fund strategies based on various reward-to-risk ratios after the 2008 global crisis. We document that a majority of hedge fund strategies deliver lower average returns compared to equities and bonds; yet the volatilities of their returns have also been low. The equity hedge strategy has the highest reward-to-risk ratios among the major strategy categories, whereas the relative value arbitrage strategy has the lowest. Technology/healthcare, merger arbitrage, discretionary thematic, and asset-backed arbitrage strategies tend to have the highest reward-to-risk ratios in their respective categories. Time-series regressions of hedge fund strategy returns on various fund pricing factors provide evidence that hedge funds, on average, do not generate abnormal returns once the pricing factors are controlled for. We also document that hedge fund strategy returns generally load negatively on the bond market and aggregate credit risk factors and positively on the market portfolio.

Investment Strategies of Hedge Funds

This chapter reviews a number of different hedge fund strategies, including equity hedge, long/short, market neutral, relative value arbitrage, convertible arbitrage strategy, capital structure arbitrage strategy, fixed income arbitrage strategy, yield curve arbitrage strategy, other relative value arbitrage strategies, emerging markets strategies, global macro strategies, event driven strategies, distressed securities, and merger arbitrage strategies. In addition, the author discusses the growth and performance of different strategies, as well as fraud, fund failures, activism, and regulation.

Financial Media, Price Discovery, and Merger Arbitrage

Using merger announcements and applying methods from computational linguistics we find strong evidence that stock prices underreact to information in financial media. A one standard deviation increase in the media-implied probability of merger completion increases the subsequent 12-day return of a long-short merger strategy by 1.2 percentage points. Filtering out the 28% of announced deals with the lowest media-implied completion probability increases the annualized alpha from merger arbitrage by 9.3 percentage points. Our results are particularly pronounced when high-yield spreads are large and on days when only few merger deals are announced.

Models and Reflexivity

This chapter considers what the distinctive advantages of using economic formulas on a trading floor are. It introduces Max, a senior trader at the merger arbitrage desk and a mathematically gifted trader. Max bet on whether announced mergers would actually be completed. More importantly, he was able to combine stock prices with economic models, plot them on a Bloomberg terminal, and estimate his rivals' expectations about a pending merger. He then used these inferred expectations to refine his own estimates of merger probability. This allowed him to test his own hypothesis against the rest of the market, question his assumptions, or ponder what he might be missing. Such possibilities reduced the risk of mistakes in Max's bets, allowing him to take larger positions and realize higher returns. The case of Max revealed what was truly new, different, and to some extent magical, about the use of models in trading.

Event-Driven Hedge Fund Strategies

This chapter explores some of the strategies used by event-driven hedge funds, namely merger arbitrage, trading distressed securities, special situations, and activism. This broad category within the hedge fund space attracts about a quarter of the capital deployed to this part of the alternatives world. Investors are drawn to the idea of uncorrelated returns that can act as a source of diversification for their portfolios as well as the ability to follow the news flow related to their investments. In essence, such trades should have identifiable catalysts and time frames. The chapter offers illustrative examples of historical trades, providing some context of the types of positions funds may take and time frames involved. Various skill sets should be sought in an event-driven manager. Managers dealing in distressed securities are likely to benefit from a legal expertise, whereas activists need to be able to influence management and campaign publically.