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Alternative Investment Strategies

Alternative Investment funds utilize a wide variety of strategies. Correlation between these strategies varies as it does with traditional equity markets. Below is a brief description of the most common Alternative Investment fund investment strategies:

Long/Short

These funds purchase undervalued securities and sell short overvalued ones. Some of these funds limit themselves to one sector, like technology or health care, while other are more general in scope.

Global or Macro

This is basically a latitude to generate a return on a leveraged basis. The managers can, for example, be long certain stocks or stock markets, short bonds and have currency and commodity positions all at the same time. Investors are relying on these individuals to exploit opportunistic investment possibilities wherever they may be found.

Dedicated Short Selling

This strategy consists of the sale of borrowed securities considered overvalued in the anticipation of purchasing them for a profit at lower prices. When used alone it is an inherently very risky strategy.

Commodity Trading Advisors (CTAs)

This strategy focuses on investing in commodity contracts.

Currencies

This strategy attempts to profit from short-term moves in the relative prices of various currencies.

Distressed Securities

This type of investing involves the purchase of securities of companies in reorganization, usually debt, and often the active participation of the hedge fund manager in the reorganization process itself. It is also referred to as Event Driven or Special Situation investing.

Market Neutral Strategies

This term has historically been associated with equity market-neutral strategies that target zero beta. However, the term has evolved to include a broad range of asset classes, which attempt to produce consistent and low volatility results, often with a target return of 10-15%.

Convertible bond arbitrage

Managers usually buy convertible bonds and warrants (instruments which are
convertible into equity), and hedge these positions by short selling the common stock of the same company.

Merger Arbitrage

Managers seek to capture the price spread between current market prices and the value of securities upon successful completion of a take-over or a merger. The price spread is due to the time value of money and a risk premium on the deal not closing. Returns in merger arbitrage arise from the correct anticipation of relative movements in stock prices.

Quantitative Arbitrage

This arbitrage embodies the disciplines of fundamental analysis and statistical analysis in studying the behaviour of securities of different companies often in the same industry or same company. By using these two types of securities analyses, a portfolio manager can identify undervalued and overvalued securities and enhance the portfolio performance by purchasing a security that is undervalued while selling short the security which is overvalued in anticipation of the market realizing the value of each security. The strategy should produce a hedged position that yields a superior return over the life of the investment. The fundamental analysis used in this type of strategy is similar to that used in the investment strategies mentioned above except that the analysis is geared to identifying the values of the two securities and determining the value of one security relative to the other. The statistical analysis involves a comparison of the statistical price behaviour of the two securities over a given period of time or economic cycle. To lessen potential risk to investors, the purchase of options may be used with this investment strategy to reduce the risk.

Long/Short Equity Strategies

Whereby equal amounts of capital are invested long and short so there is no correlation with the markets.

Mortgage-Backed securities (MBS)

Managers seek to benefit from pricing inefficiencies in the MBS market in the U.S., which is one of the largest fixed-income markets in the world. Trades include inter-market arbitrage, such as being long on cheap MBS and short of T-bill; and intra-market arbitrage, e.g. buying cheap mortgage pass-through and selling collateralized mortgage obligations. MBS trade at spread over T-bills, primarily as compensation for the uncertainty of cash flows resulting from the pre-payment option, with credit and liquidity also playing a role.

Global Fixed Income Arbitrage

These strategies involve the creation and management of offset long/short positions of fixed-income instruments, and/or their derivative, with the intention of generating returns from relative price movements between two or more correlated instruments.

Regulation D

This involves investing in micro and small capitalization public companies, which are raising money in the private capital markets. Investments usually take the form of receiving a convertible bond or convertible preferred issue in return for an injection of capital. What is unique here is that the exercise price either floats or is subject to a look back provision. This has the effect of insulating the investor from a decline in the price of the underlying stock.

High yield

The politically correct phrase for ‘junk bonds.’ Involves applying a buy-hold, or a trading strategy to high yield securities. Until recently this was primarily a US focused strategy, however it is now global and many managers focus entirely on emerging market bonds.

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