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hedge fund investing

Last time, we examined how market-neutral hedge funds “hedge” market risk with offsetting long and short positions. We looked at market-neutral equity investing in particular.

Investment professionals who hold jobs as market-neutral managers use other securities to hedge against market risk as well.

Bond hedgers try to remove the effect of broad market moves from their portfolio using long and short positions. Since attractive bonds usually have a higher yield than unattractive bonds, there is a yield spread between their long and short positions.

For example, if a high quality corporate bond offers a yield of 6.0 percent while a Treasury of comparable maturity offers a yield of 5.8 percent, the spread is 0.2 percent. If the bond hedger thinks that this is an attractive spread, then he will try to capture the spread by buying the corporate bond while shorting the Treasury.

In addition, since yield spreads are often very small, often less than 1 percent, the bond hedger will often use large amounts of leverage in order to deliver the overall return that he is seeking.

Long-Term Capital Management (LTCM) is an example of a highly leveraged bond hedging operation who’s spectacular failure illustrates the risks of bond hedging.

Long-Term Capital Management was a U.S. hedge fund which used trading strategies such as fixed income arbitrage, statistical arbitrage, and pairs trading, combined with high leverage. Initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis. This led to a massive bailout by other major banks and investment houses, which was supervised by the Federal Reserve.

The third major type of market-neutral hedging is convertible hedging. Convertible securities are either convertible bonds or convertible preferred stocks. Bonds, preferred stock and common stock represent the three different parts of the capital structure of a company.

The convertible hedger looks for situations where the convertible security of a company looks relatively cheap compared to its common stock. He will buy the convertible security and short the common stock. Or vice versa, if he thinks the common stock looks undervalued relative to the convertible securities.

Shorting the common stock removes some of the risk of owning the convertible stock yet still leaves the potential for attractive total returns. The total return has both an income component (convertible bonds and preferred stock may pay dividends) and a trading profit component. Many convertible hedgers also use leverage in their portfolios to further increase their returns.

Traditionally, buyers of convertible debt used to be conservative investors seeking a steady income stream with some potential for capital appreciation. However, Jaeger now estimates that nearly 50 percent of the market for convertible securities is snapped up by hedge fund managers pursuing convertible hedging strategies.

The market-neutral strategy can be applied to many different investment scenarios. A growth investor could buy high-growth stocks and short those with opposite traits. Or a momentum investor may buy stocks just beginning their upward movement and short stocks that have a downward momentum.

The primary goal of a market-neutral strategy is to use the short position to protect against the effects of an overall market downturn. It is fundamentally a method of managing risk. Market-neutral investing requires a manager to devote time and energy to evaluating both his long and short positions carefully to ensure that he has the best combination of securities to hedge market risk and potentially profit from the “alpha” of a performance spread.

This article just scratches the surface of hedge fund careers in market-neutral investing, of course. Entire books have been written about market-neutral strategies, including:

The Handbook of Alternative Assets by Mark J. P. Anson
Market Neutral Investing by Eric Stokes
Market-Neutral Investing by Joseph G. Nicholas
Market Neutral: Long/Short Strategies for Every Market Environment by Jess Lederman, Robert A. Klein
Market Neutral Strategies by Bruce I. Jacobs, Kenneth N. Levy, Mark J. P. Anson
Pairs Trading by Ganapathy Vidyamurthy

We strongly encourage you to explore this popular investment strategy in greater detail with one of these books.


Schwab, Claude. HEDGE ME: The Insider’s Guide: U.S. Hedge Fund Careers. Lynx Media.

Jaeger, Robert A., All About Hedge Funds: The Easy Way to Get Started. McGraw Hill.

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Market-neutral hedge funds are close to the true definition of a hedge fund, in that they “hedge” market risk with offsetting long and short positions.

A market-neutral hedge fund manager, for example, will take long positions in a company’s stock that he thinks is undervalued, and take short positions in stocks that he thinks are overvalued. The manager makes sure that the dollar value of the long position matches the dollar value of the short position, so that the total portfolio is neither net long or net short. If the long position outperforms the short position, the manager will earn the “performance spread” between the positions, plus any short-term interest earned on the proceeds of the short sale.

The basic idea behind market-neutral investing is to choose securities within a fairly homogeneous universe, balancing long versus short positions, so that the total portfolio is relatively unaffected by the overall movement of the market itself. The true driver of total return will be the manager’s skill at researching and selecting securities that he thinks will outperform the market. In theory, returns will not be affected by whether the underlying market goes up or down.

There are four major categories of market-neutral investing:

-Market-neutral equity: managers who buy stocks in what they perceive as undervalued companies, and sell short stocks in unattractive companies or an index of the market in which they are investing.

-Bond hedgers, who invest long and short in bonds;

-Convertible hedgers, who do the same using convertible securities, which are bonds or preferred shares that have an option to convert to common shares in the issuing company;

-Multi-strategy managers, who use a combination of the above strategies.

A good example of market-neutral equity investing comes from Robert A. Jaeger, in his book, All About Hedge Funds: The Easy Way to Get Started (McGraw Hill). He describes a strategy called “pairs trading.”

Suppose, for example, you thought Cisco Systems was undervalued in the market and had great potential. However, you felt that Cisco faced certain risks related to the market and economy in general or the technology sector, so you are reluctant to take an outright long position. A market neutral manager would take a long position in Cisco, offset by a short position in Microsoft. Therefore you are no longer betting that Cisco will simply go up. You are betting that Cisco will simply do better than Microsoft. Even if both companies’ stock fall in value, the trade will be profitable if Cisco declines less than Microsoft.

All market-neutral equity strategies depend on good security selection. But even then, there is no guarantee that if you buy a diversified portfolio of stocks and sell short a stock portfolio of equal size that you will automatically make money. Expectations and assumptions can be dead wrong. Stocks that appear to be undervalued can stay that way for a long time. Market-neutral equity investing is a very active form of investing and highly dependent on the skill of the portfolio manager to pick stocks that will outperform the portfolio of short positions.

According to Jaeger, the market-neutral investor is also an important source of liquidity for the markets. Market-neutral managers tend to be contrarian investors, buying on weakness and selling on strength. They add liquidity to the market for momentum investors who have the opposite trading pattern.

Next time, we’ll look at the other major subcategories of market-neutral investing: hedge fund jobs in bond and convertible securities hedging.

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