A hedge fund is a fund that invests in securities, such as stocks, bonds, currencies, or commodities. Its main focus is to earn returns by speculating on market trends, thereby taking on a variety of risks. This can involve a variety of techniques, including volatility arbitrage, fixed-income hedge fund, and event-driven hedge fund.
The fixed income segment of the market has benefited from healthy returns and relatively low volatility in recent years. However, investors' expectations have changed due to central bank efforts to erode global liquidity. These efforts have left investor confidence lagging. This has led to a migration of investors out of fixed income hedge funds.
The bond market, which is considered a direct leveraged play on the global economic cycle, is a big driver of the performance of fixed income hedge funds. While the bond market has remained flat through the second half of the year, it still has its ups and downs. Many commentators argue that the maturity of the credit cycle will suppress bond market returns. The convergence of global interest rates and the waning risk premium will also slow down returns.
The conventional fixed income hedge fund strategy is fixed income arbitrage. This approach uses both long and short positions in fixed income securities, aiming to earn profits from securities that appear to be undervalued in the market. There are several variations of this strategy, though.
The event-driven strategy takes advantage of temporary stock mispricing sparked by corporate events. The strategy also has the advantage of being market neutral, which allows it to be used in combination with other strategies. This type of strategy can be particularly beneficial when interest rate volatility is high.
This type of fund is one of the largest in the fixed income hedge fund market. Inflows are up to double digit billions of dollars so far this year. Its fee structure is relatively similar to that of a multi-strategy fund. But it has a slower tactical reaction time and higher manager-specific operational risks.
Although there are still a few notable gaps in the fixed income hedge fund space, it's clear that this industry is growing. It's an asset class that has been transformed by traders and risk managers from investment banks.
Event-driven hedge fund
An event-driven hedge fund is a sophisticated investment vehicle that takes advantage of corporate events. These may include product launches, securities offerings, restructurings and mergers. These events tend to be accompanied by stock mispricing. So, investors often prefer event-driven strategies over other types of hedge funds. But it's important to understand what an event-driven fund does and how it works before investing in one.
An event-driven hedge fund invests in a variety of financial instruments, including credit, distressed debt and high-yield bonds. It is a strategy that exploits potential pricing inefficiencies that can occur after a corporate event. An event-driven hedge fund can shift its exposure to a variety of different strategies based on corporate activities or global market conditions. This includes arbitrage, distressed investing and multi-sector strategies. It is also possible to invest in an event-driven hedge fund that is a merger arbitrage fund, focusing on the merger and acquisitions process.
In the first quarter of 2007, there was record M&A activity globally. The value of deals launched during the first four months of the year reached more than $1.57 trillion, with the US topping the list of regions with the most deals. The consolidation momentum in various sectors continued, driving the deal value up more than 41%. While there were many positives to last year, the event-driven sector also saw some negatives. The sharp sell-off at the end of February caused a drop in risk appetite, and led to muted performance for many managers. However, the second half of the year saw firms managing more than $1 billion bounce back.
As event-driven funds continue to attract capital, there are plenty of opportunities for them. Several major mergers and acquisitions are underway, including Comcast's $45.2 billion bid for Time Warner Cable and Pfizer's ongoing effort to acquire AstraZeneca. These events will likely continue to create opportunities for event driven hedge fund managers for years to come. As a result of the record mergers and acquisitions, event-driven hedge fund managers are seeing solid results. In April, 56 percent of reporting managers had inflows.
Volatility arbitrage is a strategy that involves the trading of options. These options are based on the volatility of an underlying asset. If the market is forecasting low volatility, the trader may purchase a long call option. However, if the market is forecasting high volatility, the trader may purchase a short call option. The trader profits from the difference between implied and realised volatility. This strategy is often implemented through a delta-neutral portfolio. In other words, the asset is comprised of an option and the underlying equities. The trader profits from the implied volatility of the options.
When the volatility of an underlying security increases, the price of the options tends to move more rapidly. Therefore, a trader who thinks the options are undervalued may choose to open a short position in the underlying stock. This type of volatility arbitrage is dependent on several assumptions. In particular, it is important to make an accurate forecast of future volatility. It can also be affected by correlations between securities.
Hedge funds that specialize in volatility arbitrage are not a homogenous group. Some fund managers are more aggressive than others. Some have years of declining returns while others enjoy years of flat or positive returns. When volatility spikes, volatility hedge funds have tended to make a sharp downward move. The sharper the spike, the more loss they will experience. Because these strategies are highly leveraged, they can be dangerous to limited partner investors during market stress.
Many of the larger hedge funds have a dedicated volatility trading team. They use significant leverage and sometimes dabble in other related areas. The downside is that these strategies have been subject to black swan events. In addition, it can be difficult to understand these portfolios. It can be difficult to make adjustments to these strategies depending on the market. It may be impossible to do so. Moreover, there are few names that have a good liquidity profile. Overall, volatility arbitrage has experienced some significant ups and downs over the past couple of years. It is expected to continue to be volatile.