Hedge fund strategies – what theory says!

Hedge funds have become very popular among very wealthy communities as preferred medium of investment. To our knowledge there is no standard definition of hedge funds but common characteristics of hedge fund are: private investment fund which invest in variety of asset classes and employs a great variety of investment strategies.

Even during 2008 market crash returns reported by top hedge funds were in the range of ~ 20%-30%. Where many mutual funds, stock investments and other forms of investment vehicles went off track, hedge funds proved themselves more immune to market crash.

It is difficult to get insight into strategies what top hedge funds follow in details because of typical trade secret paradigm. Most hedge fund managers keep secrets to themselves like a magic formula. However one can look into theoretical aspects what researchers explored over the period of time and can make their own strategies. In this article we try to highlight some of the theoretical methods published in literature. Let’s have a look at most common hedge fund strategies fund managers tend to follow:

  • Equity long-short
  • Event driven and special situation
  • Merge arbitrage or risk arbitrage
  • Distressed securities
  • Macro investing
  • Fixed-income arbitrage
  • Emerging markets
  • Equity market neutral
  • Sector
  • Growth
  • Value

It depends on fund manager’s taste or preferences what strategies they like to follow. One may think of mixing different strategies based on their risk level. For example a cautious investor would like to take value investing approach which many give low returns but less risky in terms of devaluating asset value. On the other hand aggressive investor may think of investing in growth companies with high P/E and/or emerging markets where there is a good potential to make more than 100% returns.

Since emerging markets tend to be more volatile than developed, it might need a detailed analysis preferable by local analyst before taking investment decisions. On the up side in those markets the potential of growth is very big. Sometimes special situation like mergers & acquisitions (M&A) may lead to good returns in very short time. There may be couple of points worth looking at in case of M&A, e.g. what is probability for merger. If probability is very high, going long in the company which is being acquired may benefit otherwise going short. It totally depends on the assessment of the market news. Companies in distress financial situations often do restructuring or reorganization.

Such news of restructuring often lead to price disparity in the market. Negative news often provoke widespread investor sell-off of the stock when few investors are willing to invest resulting in market devaluations. Often these times, if one focus on fundamental analysis and carefully do reanalysis of the stock, one may think of investing or pull out of investments locking more profits. Macro investing approaches take into consideration macro-economic factors. Macro investors often look for investments in bonds, currencies and hedge to make more profits.

Macro investing is more prone to political-economic situations of a country. Macro investing strategy focus on “big picture” analysis approach with political-economic considerations into analysis. For example price disparity due to geo-political situation can be identified in U.S. 10 years bonds and U.K. 10 years bonds. Some fund managers use tactical strategies which may use variety of investments e.g. commodities, forex, high frequency trading, derivative, options trading etc.

According to theoretical researchers they find empirical evidences for long/short strategy funds that these get benefit from shortening the positioning as compared to long bias funds (W. Fung et. al., 2011).

Goetzmann et. al. finds empirical evidences that Sharpe ratio of funds of funds index ranges from 0.31 to 0.39 in-spite of having too much differences in mean returns, which suggests that reward to the risk ratio for hedge fund investment has remain surprisingly constant. Their data suggests that most of the fund managers used fundamental and directional strategies with least standard deviation in returns for fundamental strategies and most for event driven strategies.

Brooks and Kat (2002) argued that the serial correlation of the hedge funds returns seems inconsistent with the notion of efficient markets.

There is more theoretical research needed in order to understand more about what are better strategies for better returns one can follow.


References:

  • Gregory Connor et. al., An introductions to hedge funds, London School of Economics.
  • William Fung. et. al. The risk in hedge fund strategies: Theory and evidence from long/Short equity hedge funds,  Journal of Finance
  • W. N. Goetzmann and Stephen A. Ross, Hedge Funds: Theory and performance, MIT.
  • Brooks et. al. The statistical properties of hedge fund index returns and their implications for investors, Journal of Alternative Investment.

 

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Apple stock split?

Today afternoon when I checked my portfolio, I was a bit shocked to see Apple Inc. (NASDAQ: AAPL) trading around ~ US$97 which was about ~ US$700 last week. Then I realized that its stock split has taken place which was announced a few months earlier. Apple’s stock went for 7-for-1 stock split thus creating more shares to offer to investors. In this split each 1 share holder will be awarded 6 more shares. Simultaneously the price of each stock will be divided by 7. To keep math simple, if you have 100 share worth ~US$70000 on friday, you will have 700 shares worth ~US$100. Your total value of holdings will be same and you will have more number of shares at lower price.

This is after 9 years when Apple’s stock has split. It happened earlier on three occasions, on a 2-for-1 basis in 1987, 2000, and 2005. Apple’s driving officers found telling that Apple wants to reach to more people and within their range. Lower the price, it uplifts psychological barrier in the mind of common investors who think that now its cheap to buy. This is purely psychological syndrome, math remains same. One needs to be careful biasing their decisions based on such events.

We expect that there will be a bullish reaction in the market and more people might jump into buying without much thinking and analyzing fundamentals. Apple is a darling brand of millions of people around the world but it does not mean that darling brand is good enough to give good returns on investments. One needs to watch out.

In recent years, Apple is facing a lot of competitions from other brands which are offering almost similar kind of devices at lower cost. Apple if finding hard to keep innovations going at same pace. After all technology has its own limitations. You might have seen news that Apple is on hunt to find new companies to acquire and keep itself in the race of innovations. However in recent years, you may not see much add ons in Apple products for the price it sells. Here is the hitch!! What if market reacts a bit badly, Apple stock loose its value. It happened in past, Apple stock was trading at ~US$1000 and suddenly it went down and even touched US$360 mark in two years just because of a some huge funds pulled of their investments from Apple and market took a panic. People started selling their shares and overall result Apple stock hit lowest in last few years.

It might be that Apple management is thinking that similar thing might happen after their WWDC which recently concluded as there was not much attraction or planned innovations in coming future. Bringing price below US$100 breaks a psychological barrier in people’s mind and more and more people might attracted to consider Apple as viable investment options. Thus increasing the investors base. However we fee a bit of greediness in this decision. Apple management seem to becoming too greedy which may be harmful in long run. Apple guys watch it out! Greedy destroys big kingdoms!

Now let us look at fundamentals:

Apple stock has strong fundamentals with P/E of ~15.7, dividend yield of ~3% and beta of 0.93. It’s P/B ratio is about ~4.6 which is okay for a technology company. Long term debt to equity is about 14.1 which is not bad either. ROI for last 5 years is about 30%, which is pretty good. However need to watch out its growth prospects. The US$45.5 billion in revenue reported in last quarter is about 4% increase than the revenue reported in the same quarter last year. If we look at upcoming product line, we find that there is no new innovative products coming in next few months. For some reason, company’s business deteriorated rapidly most recently. Not to mention Samsung, Google, LG, HTC etc. are giving though fight to Apple. The company’s profit margin’s have been shrinking since last three quarters rapidly. This gives an alarm!! Something mess is cooking in the management.

Note that Apple is one of our favourite company, but being favourite is because of its products not because of its managements. So, its a question whether I like to put my money in a vehicle which is driven by poor management or rather invest somewhere else where management is efficient and honest enough!

Apple’s current market value is ~4% than its book value. The valuation seems attractive. Its price-to-sales ratio is about 3.17% which is slightly than computer hardware industry ~1.6%.  Company’s cash flow is well managed with US$137 billion cash on its books. Impressive!

Since the stock split happened today, it will have too much volatility in the market towards Apple stock. The investors who are seriously thinking to invest in Apple may wait for the tide to go over. After that there will be clear indication about who much water is beneath. We expect Apple may dip down in range to 60~70 before starts gaining upwards.

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Investment in Bonds: is it a good idea?

Present economic situation is presenting a hard challenge for bond investors. Yield of government bonds is going down. There is a significant amount volatility is present with bond investment now a days. There is threat of interest rate volatility, longer term infaltion, and ongoing European debt crises for bond investors. This is a very difficult time.

However bonds remain a very valuable source of income and diversification available to investors and are part of most investment houses. Thanks to government efforts to strengthen economic recovery by keeping rates low, bond investors are sailing in grey area.

Analysts predictions for bond investors are also not in favour of long term investment in bonds. Bond investors need to be prepared for rainy days ahead in future. Governments around the globe are facing challenge for keeping economic recovery stimulus going but they may withdraw any time.

What it means that it is a signal for everyone to get out of here. Wall street firms and well known market strategists are giving alarming signals towards investing in bonds. This might be a difficult situations specially for retirees, who often put a major portion of their savings in bonds as safe investment.

There are rumours that fed may rise the interest rates in USA. What it means that bond prices will go down. Right now almost kinds of bonds, from government securities to corporate treasury notes are hitting their low peaks.

This means that troubling times are ahead for bond investors. For example $1000 invested in 10-year bonds will loose $200 in value for a 2% increase in interest rate. Italian bonds advanced after drooping from a six week high with a 10-year yield bond after the nation met its target amount in a debt auction.

We speculate that € will rise in demand versus major other currencies. 10-year bond yield fell 0.05% downt to 4.14% after climbing to 4.23%, the highest since April 19. Italy auctioned 3B € of bonds due in May 2023 at an average yield of 4.14%.

 

However its not that bad. Some countries are doing very good in present times and hopefully will continue doing that. One of such country is Germany. Germany is such a country which is famous for their engineering, hard-working people, honesty and loyalty.

German bonds are known bunds (in Deutsch). Bunds maturity range from 2 to 30 years typically. The German government bunds are considered a gold benchmark in Germany. However European economy is facing a challenge now a days.

Germany seem to be a rock stable no matter what happens with other countries in european union. The 10-year bunds yield 1.85 according to Bloomberg. Which is considered to be very good considering current economic situation. Germany maintains AAA rating which is a very good indication about the stability and low volatility for German bunds.

German bunds sold off quickly in Jan. During the last twelve months, German bunds yield advanced 0.36 percent. However, the recent downgrade of the United States debt rating and the on-going sovereign debt crisis in the European Union has cast serious doubts into risk-free assumptions for bond-market.

German economy grew by approximately 0.1 percent in last quarter after a sharp decline in end of 2012. Recent updates about German economy suggest that there will be modest growth in 2013.

 

In the end it depends on personal risk level. One needs to ask with themselves – Where my money is going? Is it worth investing in that country’s government? How much risk avers am I?

 

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AMD bouncing back?

AMD was struggling since few months and investors were skeptical about whether to invest in this company or not to invest. Since few months its stock was depressed. Since PC sales was declined in past months, AMD was not looking good. Howvever the scenario looks a bit different now and favours AMD.

AMD is a solid engineering company. AMD has a great technology and is a leader in gaming chipset market. Major gaming device manufacturing companies (Microsoft, Nintendo, Sony, Apple) are using AMD’s graphics chipset. Considering the future outlook of the gaming market and graphics chipset providers, AMD has direct competition with NVIDIA. However AMD’s graphics chipsets are more energy efficient than others which is a major factor (You would not want your device run out of battery in a gaming battle ;-)). There are many other factors why low power chips are preferred. One can go deep into engineering comparisons (e.g. device heating, reliability, life, performance etc.)

AMD is trading at $3.28 and we expect it to rise. The company has reported positive results in third quarter of 2013 beating the market expectations. The boosting sale of gaming consoles benefited AMD and the trend looks going forward. (http://www.bloomberg.com/news/2013-10-02/worldwide-video-game-console-sales-to-rise-in-2013-idc-projects.html). AMD reported its third quarter results with revenue increasing 26 percent quarter-over-quarter and 15 percent year-over-year. The company reported $48 million profit as compared to loss of $150 million a year earlier.

(snapshot taken on Nov 11, 2013 at 13.04 hrs (Eastern daylight time), courtesy: yahoo finance)

There are many other good reasons to invest in AMD. AMD is also a leader in server chipsets. The growth of cloud computing and big data centres will benefit AMD. AMD’s SeaMicro system is most energy efficient server in the market. AMD is continuing technology innovation in the areas of server, gaming chipsets which we expect is the right direction for the company to go for AMD.

AMD uses SOI technology (silicon-on-insulator) technology which offers significant advantages over bulk silicon technology which many other chip manufacturers uses: reduce parasitics, higher performance, lower power consumption, no latch-up (no extra circuity to prevent latchup, reduce area), increased density, low complexity process, reduced cross-talk, cold-sparing capability (higher system reliability). At nanoscale geometries (below 45nm) SOI technology offers great advantages over bulk silicon. As we see the future chipsets are coming at these nano-scale geometries, AMD has certainly an edge.

The sale of gaming consoles have given a boost to AMD. It has its processors in all major gaming consoles. Microsoft has highly customized its processors for their X-Box playstation. AMD’s Radeon brand processing units have always been favourite for gamers. AMD beats rival NVIDIA in gaming consoles.

We find from various sources that gaming revenue could cross $1B in 2014 which will turn out to be a clear win of those companies who are involved in the business. Since AMD is ahead of its competitors it will be a clear win if market projections are right. Nevertheless we suggest to buy AMD at the current price and expect it to rise up to ~10 in 4-5 months and at that time sell.

AMD’s accelerated Processing Units (APU) combine high performance processing cores (like many other competing mobile chipset vendors) enabling breakthroughs in visual computing, security, performance-per-watt and device form factor. AMD is clearly going to win in near future. AMD’s certainly has capabilities for a game changer.

We recommend to buy AMD at this current price $3.28 and hold it for few months. We expect that it will rise and be in range of ~ $10 in coming few months.

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Top performing Hedge Funds!

Hedge fund have been very successful in past to attract high worth investors. In a recent report by hedge fund research (www.hedgefundresearch.com), the total AUM (Assets Under Management) grew more than $2.4 trillion and held by more than 10,000 funds worldwide.

In the last quarter the inflow of money to Hedge funds was more than $55 billion. This is remarkable record for the industry. Recent inflow indicates a change in hedge fund strategies specially for the event driven strategies. With sharper rise in bond yields, investors preferences have been changed for credit and interest rate sensitive events.

HFRI Equity hedge index gained by 5.3 percent in the first half and looks for brighter future. Technology, healthcare and fundamental value funds gained 8.9, 8.9, and 8.6 percent respectively.

The cash-flow happened for almost all funds more than $500 million under management. In addition to cash-flow, the number of funds has also been increased. “Hedge fund managers and investors continue to position for a post-QE environment dominated by fundamental, mean-reverting and trend-following factors, with these in contrast to the macro policy and stimulus-dominated environment of recent quarters,” said Kenneth Heinz, president of HFR.

 

Top performing hedge funds to date

 

  • Metacapital Mortgage Opportunities: Metacapital Management | USA | $1B | YTD Returns: 37.8 % | Mortgage-backed arbitrage
  • Pine River Fixed Income: Pine River Capital Management | USA | $3.6B | YTD Returns: 32.9 % | Mortgage-backed arbitrage
  • CQS Directional Opportunities: CQS | UK | $1.5B | YTD Returns: 28.9 % | Multistrategy
  • Pine River Liquid Mortgage: Jiayi Chen Pine River Capital Management | USA | $1.1B | YTD Returns: 28.0 % | Mortgage-based arbitrage
  • Omega Overseas Partners A: Omega Advisors | USA | $1.4B | YTD Returns: 24.4 % | Long-Short
  • Odey European: Odey Asset Management | UK | $1.8B | YTD Returns: 24.1 % | Macro
  • Marathon Securitized Credit: Marathon Assets | USA | $1.2B | YTD Returns: 24.0 % | Asset Backed
  • Palomino: Appaloosa Management | USA | $4.9B | YTD Returns: 24.0 % | Multistrategy
  • BTG Pactual GEMM | USA | $3.6B | YTD Returns: 23.1 % | Macro
  • Third Point Ultra | USA | $1.3B | YTD Returns: 22.1 % | Multistrategy
  • Seer Capital Partners | USA | $1.2B | YTD Returns: 21.6 % | Asset backed
  • Tiger Global | USA | $6.0B | YTD Returns: 21.0 % | Long-Short
  • Eminence | Eminence Capital | USA | $3.0B | YTD Returns: 20.9 % | Long-Short
  • Jana Master | Jana PArtners | USA | $3.8B | YTD Returns: 20.4 % | Event driven
  • Structured Servicing Holdings | Structured Portfolio | USA | $1.9B | YTD Returns: 20.3 % | Mortgage-backed arbitrage
  • Citadel Tactical Trading | Citadel Advisors | USA | $1.0B | YTD Returns: 20.0 % | Long/Short
  • Viking Long | Viking Global Investors | USA | $1.7B | YTD Returns: 19.4 % | Long biased
  • Cerberus RMBS Opportunities | Cerberus Capital | USA | $1.7B | YTD Returns: 19.0 % | Distressed
  • Liber Max Partners | LiberMax Capital | USA | $2.3B | YTD Returns: 18.5 % | Structured Credit
  • Pine River | Pine River Capital | USA | $1.6B | YTD Returns: 18.5 % | Multistrategy

 

 

Sources: Bloomberg.

 

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