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Fixed income strategies include the hedged strategies that invest in bonds and other fixed income instruments

Fixed Income Hedge Funds

Fixed income strategies include the hedged strategies that invest in bonds and other fixed income instruments. Fixed income strategies include fixed income arbitrage, mortgage funds, various default-risk funds, and emerging markets debt funds.

Fixed Income Arbitrage Fixed income arbitrage funds rely primarily on debt instruments. Sometimes the group is called just fixed income fund to recognize that some of these funds retain substantial risks, albeit typically not the risk of rising or declining rates. The funds combine long and short positions with derivative instruments to hedge the level of interest rates, the rates of one maturity sector versus other maturity sectors (the yield curve), credit risks, and other factors.

Fixed income arbitrage funds have very effective hedges because interest rates tend to move up and down together (to a lesser extent when hedges span international borders or involve significantly different default risks). Because these hedges remove much of the day-to-day portfolio risks, arbitrage funds or arb funds usually have the highest leverage of all hedge fund strategies.

Fixed income arb funds may have sizable positions in foreign currencies but the currency exposure is usually hedged away. Similarly, the funds frequently buy individual issues that have considerable interest rate risk. However, this category of hedge fund would hedge away most of this risk.

As a group, fixed income funds have produced the lowest returns over time. However, the returns are rather consistent over time and the funds have low volatility of returns. The performance is nearly independent of stock and bond returns. Fixed income funds are viewed as more risky than the historical data would suggest because several fixed income funds have failed and created a major impact on the markets. For example, both the Granite Fund and Long-Term Capital Management lost nearly 100 percent of their capital while investing primarily in fixed income assets. Each of these highly publicized failures was accompanied with dislocations in the fixed income markets.

Mortgage -Backed and Collateralized Debt Obligations Mortgage-backed securities (MBSs) include a variety of bonds backed by mortgage loans. Most mortgage loans (especially residential loans) can be repaid with little or no penalty at any time. This right closely resembles an option because the homeowner can refinance if rates decline but force a lender to hold to a fixed rate if rates rise.

When borrowers repay these mortgage loans, investors must reinvest, often at a lower rate. A variety of engineered securitiescollateralized mortgage obligations (CMOs), real estate mortgage investment conduits (REMICs), and interest-only (IO) and principal-only (PO) notesdivide the many risks of the underlying loans in ways that may be more attractive to most investors. As it works out, much of the option risk gets distilled into a couple of high-yield, high-risk assets. Usually MBS strategies concentrate on buying this tricky category and hedging the many risks present in the investment.

Collateralized debt obligations (CDOs) resemble the engineered mortgage securities except that they involved other debt instruments, usually moderately low to low grade corporate bonds. Hedge funds use these instrumentsincluding collateralized loan obligations (CLOs) and collateralized bond obligations (CBOs)to earn credit spread without taking substantial interest rate risk, to arbitrage against other credit default instruments, or as a way of financing positions.

The MBS and CDO funds are often included in the fixed income category of hedge funds. Like the other fixed income funds, these funds have had lower average returns and lower volatility of returns than most hedge fund strategies. Investors have become nervous about holding MBS hedge funds after the losses at Granite fund and other mortgage funds, which probably explains why this sector remains small.

Credit , Bankruptcy, and Distress This category of hedge fund is listed with other fixed income strategies. But while these funds tend to invest in debt instruments of financially troubled companies, the category is broad enough to include equity investments.

Generally, hedge funds buy and hold debt instruments of companies in or near default. Hedge funds may sell short securities of some companies. The managers may create hedges, buying one security and selling short other issues of the same company (hedging debt by selling common, for example) or instruments of other companies. The hedge fund may also hedge a portfolio of instruments with credit derivatives.

Most of the data vendors track a distress category of hedge funds. Performance has been fairly high on distress hedge funds, with low to moderately low risk. In general, these funds tend to do best when stock returns are positive. There is a moderate tendency for these funds to do well when rates rise. These funds also do well when securities markets are calm. For example, most indexes of bankruptcy and distress strategies are negatively correlated with the VIX index of stock option volatility (when volatility declines, these funds do well).

Emerging Markets As the name of the category suggests, emerging markets hedge funds invest in securities issued by companies or countries that dont have well-established securities markets. These investments can be either debt or equity investments. Hedge funds may acquire a widely diversified portfolio of instruments from many countries or may focus on a particular country or economic region.

Generally, these funds cannot or do not hedge the risk in these portfolios, either because there is no futures or derivatives market for hedging or because the fund manager wants to retain the market exposure. Because the securities are fairly risky and generally unhedged, these funds tend to use little or no leverage.

Emerging markets hedge funds have been among the highestperforming groups, although the category shows up as only average in the performance data published by some data providers. The strategy produces inconsistent returns, having one of the highest volatilities of returns of all hedge fund strategies (about equal to an unlevered investment in the Standard & Poors 500 index). The strategy is moderately correlated to stock returns (around 50 percent versus the S&P 500). Like

most hedge fund strategies, the performance in emerging markets hedge funds is correlated to the level of uncertainty in the financial markets. For example, the strategy has a correlation of about -30 percent versus the VIX index of stock option volatility (the funds do well when volatility declines).

Other Hedge Fund Strategies

With 8,000 or more hedge funds in existence, it is not surprising that they do not fit neatly into a few categories. Other categories are important not so much because of the assets committed to these strategies but rather because they extend the range of investment opportunities.

Global Macro The global macro hedge funds brought the concept of hedge fund trading to the attention of many investors for the first time. These funds generally started out as equity portfolios but the managers also traded debt and foreign currency. Despite being called hedge funds, these funds generally take speculative, directional positions in stocks, bonds, and currencies worldwide, based on macroeconomic forecasts.

Global macro hedge funds have some of the highest returns of all hedge fund strategies. Nevertheless, the volatility of returns is (at least as a group) lower than stock market volatilities but considerably higher than most hedge fund strategies. Because these funds may take either long or short positions and carry positions from a broad universe (including many emerging markets), correlation to stock and bond returns is relatively low (20 to 40 percent correlation to stock returns and 20 to 30 percent correlation to bond returns). This group has a higher correlation to bond returns than most hedge fund strategies.

Currency Currency hedge funds may be seen as a particular kind of global macro hedge fund. However, this group invests in currencies strategically and invests in fixed income markets only incidentally or as part of an arbitrage strategy. The group contains arbitrage traders that produce low returns but take little risk. The group also contains funds that take strategic positions in a variety of currencies (not necessarily hedged and generally not part of arbitrage positions). This second group is an example of a portable alpha strategy. A portable alpha strategy is an investment strategy, possibly part of a traditional, long-only portfolio strategy that has favorable performance and can be recast as a strategy that: (1) is extracted from the traditional portfolio and (2) could be added to any type of portfolio to improve the return on the portfolio. These traders have adapted trading styles from other types of investment vehicles to create a nondirectional investment strategy.

Funds of Funds

Funds of hedge funds invest in other hedge funds. On the surface, this seems redundant and the investor might hesitate to pay fees to a fund of funds manager on top of the fees paid to the managers directly managing the funds.

Funds of hedge funds have several advantages to both large institutional investors and investors with considerably less sophistication and with smaller portfolios. First, the minimum investment is often smaller for a fund of funds than for a hedge fund. Second, the fund of funds invests in many funds, so the investor gets some risk reduction from diversification, especially for investors who have limited resources to invest in hedge fund assets. Third, the fund of funds may negotiate a reduction on fees so an investor may not pay significantly higher fees investing through a fund of funds intermediary. Fourth, the fund of funds manager may have access to information about funds and may perform analysis of funds that improves return or reduces risk. Fifth, the fund of funds manager may be able to invest in funds otherwise closed to new investment because of agreements made to get preferential access to hedge fund capacity.

SUMMARY AND CONCLUSION

It is impossible to classify 8,100 hedge funds into a dozen categories. The strategies or styles described in this chapter include the largest categories.

Each of these styles is tracked by one or more data provider. While these categorizes may be defined somewhat inconsistently, they nevertheless serve as a helpful resource to the fund investor.

The performance of the many styles of hedge funds derives from the inherent characteristics of the assets in the hedge fund portfolios. The performance is also affected by the way the instruments are combined. The resulting returns can be predicted in an important way. It is difficult to forecast the performance of a particular fund or sector next month. It is possible, though, to predict which hedge funds will do well (or poorly) if certain things happen (rising interest rates, changes in corporate borrowing spreads, rising volatility, etc.). Because of this predictability, investors can combine these hedge fund assets with traditional portfolios to improve the risk and return characteristics of their portfolios.

QUESTIONS AND PROBLEMS

2.1Why do so many organizations provide hedge fund indexes?2.2What is a long/short equity hedge fund?2.3What is an equity arbitrage hedge fund?2.4What is an equity pairs strategy?2.5What is an equity market neutral hedge fund?2.6What are some of the types of strategies an event driven hedge fundwould pursue?2.7Describe the nature of a convertible bond investment.2.8What kinds of trades would you expect to find in a fixed income arbi-trage hedge fund?2.9What kinds of securities would you expect to find in an emergingmarkets hedge fund?

2.10 What is the biggest risk to an investment in a distressed securities

hedge fund?

2.11 What kind of fund would call itself a global macro hedge fund? 2.12 What is a fund of funds?

You own a portfolio of common stocks that more or less tracks the stock index in the preceding table. The statistics are historical but you believe they are reasonable forecasts of future returns. Rely on the following table to answer questions 2.13 to 2.17.

32HEDGE FUND COURSEPerformance of Hedge Fund Styles (Hypothetical)StandardCorrelationFund StyleReturnDeviationto StocksConvertible arbitrage8.00%4.33%10.00%Global macro12.00%12.99%25.00%Long/short equity10.00%8.66%50.00%Stock index10.00%17.32%100.00%

2.13 What is the expected return on the portfolio if you reallocate 10 percent of the stock portfolio into a convertible arbitrage hedge fund? What is the standard deviation of the portfolio comprising 90 percent stocks and 10 percent convertible bond hedge fund?

2.14 What is the expected return on the portfolio if you reallocate 10 percent of the stock portfolio into a global macro hedge fund? What is the standard deviation of the portfolio comprising 90 percent stocks and 10 percent global macro hedge fund?

2.15 What is the expected return on the portfolio if you reallocate 10 percent of the stock portfolio into a long/short equity hedge fund? What is the standard deviation of the portfolio comprising 90 percent stocks and 10 percent long/short equity hedge fund?

2.16Based on your results in questions 2.13 to 2.15, which hedge fundshould you invest in?

2.17 Suppose you could invest in a hedge fund that would provide an expected return of 8 percent and have volatility of 20 percent with a correlation of 50 percent to stock returns. Should you move some of the stock money into this fund?

2.18 An individual has half of the family net worth tied up in a closely held public business and the balance in a broadly diversified portfolio of common stocks. What special concerns would this investor have in selecting a hedge fund style?

2.19 What advantages does an investor get from investing directly in a portfolio of individual hedge funds rather than investing in a fund of funds?

2.20Why do so many different hedge fund styles exist?2.21Why would an investor put money in a hedge fund that followed ashort-only strategy?

2.22 How is it possible to reconcile the low measured risk (at least in terms of the standard deviation of return) of the fixed income arbitrage strategy and the investor perception that this is a risky strategy?



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200605-01There are many reasons to categorize hedge funds and group them into subsets

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