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Convertible bonds and convertible preferred stock are hybrid securities

Equity Market Neutral Dividend Capture

Dividend capture is usually not conducted with market neutral positions but, because of the short holding period, the performance of the strategy does not closely track stock market indexes.

Stock prices reflect the timing and magnitude of dividend payments (among other factors). Corporations announce a dividend payment to be paid to all holders on a particular future date (the ex-dividend date) payable a short time later (the dividend payment date). Prices of stocks move down on the ex-dividend date because buyers of the stock will not receive the announced dividend and sellers of the stock will nevertheless keep the dividend.

Pending orders on most stock exchanges are lowered by the amount of the dividend on the ex-dividend date. However, stocks generally decline on the ex-dividend date by less than the amount of the dividend. If all investors paid tax at the same rate, the decline in price should on average equal the after-tax amount of any announced dividend. In practice, investors pay many different tax rates, ranging from zero for pension funds, foundations, and endowments to the maximum tax rate on ordinary income (35 percent in the United States for 2003). Taxable U.S. investors may pay a lower tax rate for capital gains than for income. Offshore investors may also have a preference for gains over income. The price of a stock tends to fall by less than the amount of the pretax dividend but more than the after-tax dividend, using the maximum personal income tax rate.

A hedge fund can capture a dividend by buying the shares near the end of the day preceding the ex-dividend date and selling the stock early the next trading day. For this overnight exposure, the hedge fund can expect to receive a dividend in a few weeks and an immediate capital loss slightly smaller than the dividend. U.S. hedge fund investors would pay the same tax rate on the short-term capital gain or loss as they pay on ordinary income. Similarly, offshore investors pay no U.S. tax on either the price difference or the dividend income.

The hedge fund is also exposed to gains and losses during the time the fund holds the shares. The hedge fund can hedge the general direction of stock prices by selling an index future but will generally not hedge movements in the specific securities. Over time, if index prices are flat, the hedge fund can expect to accumulate capital losses and ordinary income. The hedge fund must be careful not to produce losses that cannot be deducted on the tax returns of hedge fund investors.

Convertible Arbitrage

Convertible bonds and convertible preferred stock are hybrid securities, having many of the characteristics of debt and many of the characteristics of equity. Investors have a built-in option to convert from the debtlike instrument to regular common stock. This option can be very valuable. Often, convertible bonds or preferred shares are issued by young companies whose common stock is capable of significant gains or losses.

The option may be difficult to value because the issue may contain other provisions. The option grants the right to convert for a specific period beginning in the future and continuing to a specified expiration date. The terms of the conversion may change over time. The issuing company may also own a call option or other provisions to force the owner of the convertible security to convert.

To complicate the valuation, realize that the conversion option gives the owner the right to exchange one asset (the bond or preferred shares) for common stock. Frequently, the value of the bond or preferred stock moves up and down along with the value of the common stock. If the company is successful, its stock rises because of the prospect of higher earnings. The value of its debt also rises because bondholders face lower risk of default. If a company does poorly, its stock declines. The value of its debt may also decline because of the heightened risk of default.

The convertible arbitrage fund usually buys the convertible issue and sells short the underlying common stock as a hedge. As constructed, this combination will generally be profitable if the common stock moves up or down significantly but will usually lose money if prices remain steady.

Hedge funds may design an option hedging strategy to increase the consistency of performance. The fund may sell listed or over-the-counter stock options to approximate selling the option rights in the convertible security. Properly constructed, the strategy may enable the hedge fund to expect to make money regardless of whether the common shares rise or decline and whether the movement is great or small.

Fixed Income Arbitrage

Fixed income arbitrage incorporates a number of strategies. The largest risk factor for most bonds is the general level of interest rates. Most interest rates tend to move up and down together, so a short position can closely hedge a long position for most fixed income securities.

Like the equity index arbitrage strategy, a hedge fund may buy bonds and sell futures. This trade is called the bond basis and has optionlike characteristics. The combination is a low- risk strategy and is profitable when interest rates move up or down significantly from the beginning level. The trader profits from the optionality of the relationship when large movements occur.

Fixed income arbitrage funds may also hedge long positions in cash securities by selling combinations of Eurodollar futures. Generally, traders seek out bonds with somewhat higher yields because they are not free from default. Then, the hedge fund makes money over time, as long as yield spreads remain steady or narrow to smaller spreads.

Fixed income hedge funds may also buy and sell combinations of securities, hoping to profit from changes in the relationship between the long positions and the short positions. For example, a fund might buy short-term securities and sell short long-term securities, hoping that the yields on the short instruments will decline relative to the yields on the longer issues. This trade is called buying the curve. Although these trades may be constructed to be neutral to a general rise or decline in rates, the positions make or lose money based on the performance of the individual sectors.

Mortgage /Asset -Backed Arbitrage

Fixed income arbitrage hedge funds may use mortgage-backed securities or asset-backed securities to construct market neutral portfolios. Mortgagebacked securities are securities that are created from pools of mortgages. Most of these securities are issued as pass-through securities by Freddie Mac and Fannie Mae, although many have been reissued as collateralized mortgage obligations (CMOs), interest-only (IO), and principal-only (PO) notes, and other mortgage derivatives. Mortgage-backed securities present a challenge in constructing and maintaining a market neutral portfolio because these securities reflect the prepayment option granted to the homeowner on the underlying mortgages.

Asset-backed securities are created from a wide variety of loans, although most asset-backed securities are created from consumer loans, such as credit card receivables and automobile loans. Asset-backed securities do not present the hedging challenge of mortgage-backed securities. Instead, the investor faces the risk of default.

Several hedge funds have faced challenges running mortgage-backed strategies, including the well-publicized bankruptcy of the Granite Fund and financing challenges at Ellington3 and MKP Capital. The first essen

tial ingredient needed to run either mortgage-backed or asset-backed arbitrage strategies is to have a robust valuation model. If the valuation model is sound, then the hedge fund can measure the sensitivity of the positions to changes in interest rates, credit spreads, volatility, and other factors. The second essential ingredient is having a strategy for surviving periods when these types of securities go out of favor with investors. It is important for hedge funds to maintain some borrowing capacity for times when these assets are subject to distress pricing and lenders raise margin requirements.

Fund of Funds

The fund of funds is a hedge fund that invests in other hedge funds. These portfolios offer several advantages over investment directly in hedge funds. First, the funds of funds diversify the returns and reduce the volatility of performance. Second, the fund of funds manager investigates the funds it invests in and may be able to reduce the chance of losses to fraud or mismanagement. The fund of funds manager may also be able to identify funds likely to have superior performance.

Most funds of funds are skilled marketing organizations. Not surprisingly, the composition of funds of funds tends to migrate toward the popular hedge fund strategies. A small number of fund of funds managers make forward-looking asset allocations, based on internal forecasts of profitability of various strategies. Other fund of funds managers emphasize diversification strongly and are less likely to overweight particular strategies. The classic method of portfolio selection first identified by Harry Markowitz4 involved searching for the optimum trade-off between risk

and reward. It is fairly easy to build a model to select hedge funds to get a portfolio with high expected returns and controlled risk. Many fund of funds managers have models or seek to build similar portfolios in other ways.

Unfortunately, the realities of fund of funds management and administration prevent managers from implementing their model portfolios. Many hedge funds impose significant lockups, preventing the fund of funds manager from removing funds from one hedge fund to redeploy in another. Even when exit is permitted, hedge funds wont redeem investments until the next accounting break period (the monthly or quarterly intervals when investors can enter or exit) and other funds wont accept new investments until they reach a break period. Finally, even if a fund of funds is permitted to exit, the manager will usually try to remain in the existing hedge funds because it may be difficult to reenter a hedge fund after withdrawing funds from a particular hedge fund.

As a result, the typical fund of funds manager at best implements an approximation of the model portfolio. The manager must rebalance by reducing the weight of the most successful strategy, which will be overweighted. If the fund of funds manager is growing, the manager may direct money to a small number of managers and partially rebalance, rather than making a proportionate investment in all managers. If the fund of funds is losing investment funds, the manager will raise cash from the hedge funds that permit withdrawals, even at the expense of distorting the balance in the portfolio.

SUMMARY

The introductory chapter presented a definition of hedge funds, despite the lack of clear divisions between hedge funds and other types of investment accounts. This chapter on investment techniques reflects the grayness of that definition. All the techniques described in this chapter are used by other types of investors as well as hedge funds. Notably, many of the techniques were developed by proprietary traders within broker-dealers.

Hedge funds have adopted these techniques along with conventional investment techniques to create desirable returns for their investors. The techniques described are more sophisticated and often require trading that is either prohibited or untypical of mutual funds, trust accounts, and conventional investment advisory accounts. Because the techniques create a pattern of returns that dont track stock and bond returns closely, they provide a way for the hedge fund investor to improve the return and risk characteristics of a traditional portfolio.

QUESTIONS AND PROBLEMS

4.1 A hedge fund manager claims to have a black box. None of the investment decisions are left to the discretion of the hedge fund traders. Is the black box a technical trading strategy?

4.2 A hedge fund hears a rumor that Company X is considering making a takeover bid for Company Y. The hedge fund buys shares in Company Y, hoping to profit from a run-up in price when the bidding is announced. Is this a merger arbitrage trade?

4.3 Suppose Company X announces a bid for Company Y to be paid in cash. Should the merger arbitrage trader sell Company X shares to hedge a purchase of Company Y shares?

4.4 A trader estimates that he can make $5 per share after financing costs and commissions if the merger is completed at $105. However, if the deal is not completed, the position could lose $10. Explain why the trader might justify risking a 10 percent loss to try to capture a 5 percent gain.

4.5 XYZ L.P. operates as a merger arbitrage hedge fund. Is it likely that the manager of XYZ prefers to enter into takeover events where the acquiring company has a high dividend and the target company has a low dividend?

4.6Why is a hedge fund a good structure for investing in bankruptcy-prone companies?

Hedge Fund Investment Techniques71

4.7 You run a multistrategy hedge fund. An employee proposes trading pairs of stocks. Is that a good strategy to add to a complicated mix of hedge fund strategies?

4.8 Would an endowment or foundation be interested in a hedge fund that relies on a dividend capture strategy?

4.9What are the major risks taken by a convertible bond arbitrage hedgefund?

.10 Many investors worry that the fixed income arbitrage strategies in

volve a pattern of many small profits over and over followed by a large and unpredictable loss. Explain why this pattern may or may not be an attractive pattern of return for a hedge fund investor.

4.11 Problems with mortgage trades have occurred when interest rates have been rapidly declining. If you believe interest rates will rise, should you invest in mortgage strategies?

4.12 Why might it be desirable to overweight a fund of funds into the popular hedge fund strategies?



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Previous Issues

200605-06Hedge funds differ from other types of trading entities in many ways

200605-05The reinsurance companies that invest in hedge funds have generally been closely associated with particular hedge fund managers

200605-04Foundations often invest in hedge funds by hiring consultants to aid in determining a portfolio strategy

200605-03The individuals and institutions that invest in hedge funds are surprisingly different

200605-02Fixed income strategies include the hedged strategies that invest in bonds and other fixed income instruments

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

200604-30Commodity pools are structured using the same types of businesses used to create hedge funds

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