Equity Hedge Fund Strategies

What Are Equity Hedge Fund Strategies?

Equity hedge fund strategies include long and short positions prominently in equity and equity derivatives. An equity hedge fund strategy typically uses a broad range of investment processes, including both, quantitative and fundamental techniques.

Equity strategies focus on investing in equity instruments, which include broad market indices and individual securities.

The strategies can be designed in many different ways. The main driver is the philosophy and investing style of the fund. It is common to take only a long or short position or both. Classification of these strategies mainly depends on the size and sign of market exposure.

Market exposure can be positive, negative, or neutral, that is, zero. Each strategy's return and risk profile varies based on the exposure and leverage used.

Market exposure, or Beta, measures systematic risk or volatility relative to a broad market equity index. A beta greater than 1 indicates positive market exposure, which means that an asset or portfolio strategy is more volatile than the market index. 

When the beta value is 1, the investment has the same volatility as the market index. However, it will be less volatile than the market when the Beta is less than 1.

Expected Change in Stock = Beta of Stock* Expected Change in the market index.

Consider the Beta of the stock is 1.4, i.e., it has positive market exposure, and the Market index is expected to appreciate by 10%. Thus, the expected change in the stock will be +14%. The stock will increase by 14% if the market increases by 10%.

Understanding Equity Hedge Fund Strategies

Equity hedge fund strategies function by maintaining long and short positions in the equity and equity derivative markets. They aim to minimize market exposure while profiting from stock gains in long positions and price declines in short positions.

But, what are long and short positions?

• The long position refers to equities that are expected to rise in the future and are bought to gain profits from the upward trends
• The short position refers to securities and debt borrowed from a brokerage that is sold to gain profits from repurchasing them at lower prices.

These strategies are known for exploiting the market movement aiming to optimize the results by optimizing returns, increasing profits, limiting risk exposure, and capitalizing the market inefficiencies.

The equity hedge fund managers maintain at least 50% exposure to equities. This is usually done with the help of employing sub-strategies like the following:

1. Equity Market Neutral
2. Long/Short
3. Event Driven
4. Quantitative/Algorithmic Trading
5. Sector-specific Strategies, like, Energy/Basic Materials, Healthcare, Technology, and
6. Short/Long Bias
7. Global Macro

Types Of Equity Hedge Fund Strategies

Equity hedge fund strategies are investment techniques that are primarily used for investing in equities and equity derivatives. These strategies aim to generate an alpha, a return on equity investments that exceeds the market average. 

Some of the common equity hedge fund strategies include the following:

Long/Short Equity

By employing this strategy, equity hedge fund managers identify the stocks that are undervalued (long position), believing they will increase in the future, and overvalued stocks will decrease in value (short position) in the future.

By doing this, managers can mitigate the risk by making use of positive and negative market movements.

Market-Neutral Strategies

This strategy aims to minimize overall exposure to market movements by balancing long and short positions. The goal is to generate profits through investments in equities alone, not through general market movements.

This particular strategy combines the merits of long and short positions in stocks or sectors to minimize risk by hedging them.

Event-Driven

Fund managers utilize this technique to take advantage of a corporate event by identifying the mispriced securities and making the most of the opportunities through price movements resulting from the event.

These corporate events can include mergers, acquisitions, takeovers, bankruptcies, and other influential corporate events.

Quantitative or Algorithmic Trading

This type of trading encompasses the use of algorithms and mathematical models to understand and exploit market movements to generate revenues. The models mentioned utilize a large number of data sets to unearth patterns and trends.

Decisions here are taken based on the outcome of data, and trades are executed automatically based on predefined criteria.

Sector-Specific

Equity hedge fund managers can specialize in different industries and sectors. These sectors may include technology, healthcare, and energy, among many others. Managers can pool and focus their expertise on all or one of these sectors to gain insights and knowledge about investment opportunities and construct healthy and sound portfolios.

Long Bias

Many firms and fund managers promote the idea of long bias, a technique for holding long positions in equity. This involves holding undervalued stocks, thinking their value will increase in the future.

Global Macro

This strategy aims to invest in other asset classes while remaining focused on equities. Global macro fund managers make decisions based on macroeconomic trends, geopolitical events, and other factors influencing the global market. 

What are the common characteristics of equity strategies?

The three strategies differ based on the market exposure and risk/return profile. However, they also have common characteristics as compared to other asset classes.

1. High fee structure: The fee structure includes a management fee and an incentive fee. The management fee is usually 1% or more of AUM. The incentive fee, which can be 10%—20% of annual returns, is up to the hedge fund to include the high-watermark provision.
2. Low Transparency: These hedge fund strategies lack transparency. Transparency allows investors to see and understand what the manager is doing with their money. Hedge funds use it to avoid liquidity runs and reveal the source of alpha.
3. Not Obligated to disclose returns: They have fewer legal and regulatory requirements as compared to mutual funds. Thus, the need to disclose HF's performance to meet regulatory requirements is less.
4. Survivorship Bias: Only the best-performing hedge funds disclose their returns. Funds that do not perform well are not obligated to disclose their poor performance. Hence, the return data for these strategies tends to be smoothed and is a biased estimate.
5. High Investment: The minimum investment to get exposure to this asset class is high. Only sophisticated investors who can meet the minimum investment are allowed to participate. Retail investors can gain exposure through Liquid Alternatives.
6. High Leverage: The use of leverage is usually high but will vary based on the strategy employed to earn meaningful returns.
7. Low liquidity: The strategy has an initial lock-up period which can vary from one to two years. They also have redemption windows and liquidity gates. This illiquid nature and the use of complex strategies can hinder the participation of retail investors.

What is a Long-Short equity hedge fund strategy?

Hedge funds employing long-short equity strategies take both long and short positions. The total long positions can vary from 65% to 90%. The short position in the portfolio can vary from 20% to 50%. Thus, long-short equity positions have a net long position varying from 40% to 60%.

HF will buy undervalued companies and sell overvalued companies. The goal is to identify attractive long and short-investment opportunities, and the position taken on each side will depend on the desired exposure.

Long positions in companies that are expected to appreciate shortly. Short positions are taken in investments expected to depreciate or fall in value. 

They can be based on investment styles (value vs. growth) or geographic regions (domestic vs. international). This can be further categorized based on

• Market capitalization,
• Orientation, and
• Valuation approach.

Long/short funds also use other strategies to mitigate market volatility, including leverage and derivatives. Because exposure is dynamic, derivatives are preferred to gain the desired exposure.

What are the Investment characteristics of Long short equity hedge fund strategy?

The return profile of a long-short strategy is similar to the long-only equity strategy. However, the volatility or standard deviation is significantly less than the long-only strategy. Thus, the Sharpe ratio of long short is much higher than the long-only strategy.

The source of excess return relative to an appropriate benchmark is attributed to the portfolio manager's stock-picking skill. In addition, the manager can be highly skilled in a particular industry, investment style, and region. Asset allocation also plays a big role in determining returns.

The performance of long-short HF during market crises is important to differentiate between funds. 

Managers can be opportunistic as they can take short positions after discovering overvalued opportunities. However, managers can also take short positions to hedge market risk.

HF can finance a part of its portfolio via short positions. Thus, the use of leverage in the strategy is variable. The use of leverage is high for a more quantitatively oriented strategy. Leverage is used to generate meaningful returns.

Portfolio managers that specialize in Long-short strategy can be generalists or specialists. Generalist portfolio managers invest across different sectors. As a result, they can generate Beta, the excess return over the market index. However, the ability to generate alpha is limited.

Specialist portfolio managers invest in specific sectors, which require specialized knowledge to understand the sector as they are difficult to analyze. Nevertheless, they can generate an excess return over an appropriate benchmark.

Idiosyncratic risk is high for specialist managers. Generalist managers invest in different sectors and can diversify away the idiosyncratic risk.

What is a Dedicated Short-bias hedge fund strategy?

Dedicated short-biased strategies mainly identify overvalued investment opportunities. However, this can also include companies with deteriorating fundamentals. The goal is to take short positions in the investment opportunities expected to depreciate.

Managers look for stocks that are extremely overpriced in comparison to their fundamentals. They look for deteriorating fundamentals, aggressive accounting methods, and materially overstated earnings. This gives managers a sense of headwinds.

Exposure to the dedicated short bias strategy can be adjusted by holding cash. However, the strategy will have an overall short position between 55% to 120 %. Thus, a high degree of conviction is required to enter this trade.

Other variants of this strategy include short biased strategy. The short-biased strategy has both long and short positions. The strategy has a net short position of 30% to 60%. The long position is attractive in offsetting some losses during the equity market bull run.

What are the investment characteristics of a Dedicated short-bias hedge fund strategy?

Returns are lower here as compared to the long-only strategy. Volatility is also much higher as compared to other equity strategies. However, the main attractiveness is the ability to offer negative correlation benefits.

A negative correlation is attributed to the net short position of the strategy. Portfolio managers use this strategy specifically to offset the losses faced by other equity strategies. Empirical evidence suggests that the returns are lumpier.

The use of leverage is low as the short positions offer natural volatility exposure. Accounting tools can be used to identify potential candidates. For example, Altman Z is used to identify how likely a company is to go bankrupt.

The formula for Altman Z-Score:

Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 + 0.99 X5

Where:

• Z = Altman Z- Score
• X1 = Working Capital/ Total Assets
• X2 = Retained Earnings/ Total Assets
• X3 = EBIT/ Total Assets
• X4 = Market Value of Equity/ Total Liabilities
• X5 = Sales/ Total Assets

Altman's score of less than 1.8 indicates that the company will soon face bankruptcy. A score of more than 3 indicates that the company is fairly stable and not expected to face bankruptcy. The outlook for companies with scores between 1.8 and 3 is difficult to predict.

Beneish’s M-score is also used to check the earnings quality. However, explicit reliance on these ratios is not advisable, as the companies know about the tweaks needed to get the desired score. In addition, borrowing costs and the risk of a short squeeze can limit the implementation of the strategy.

What is an Equity market-neutral hedge fund strategy?

Equity market-neutral strategies take long and short positions in related companies or investment instruments. This portfolio strategy has a net long work and a market exposure of zero. Overall, it helps to immunize the portfolio against market risk and generate a steady return.

Pairs, stub, and multi-class trading are three types of EMN strategy. All three strategies focus on generating a positive return while having market-neutral exposure. 

1. Multi-class trading focuses on buying and selling different classes of shares of the same company.
2. Pairs trading focuses on identifying stocks that have diverged from their historical mean. It focuses on identifying overvalued and undervalued companies with strong historical correlations. A long position is taken in undervalued stocks, and a short position is taken in overvalued stocks.
3. Stub trading focuses on the relationship between a parent company and its subsidiary. A short position is taken in a subsidiary if it is overvalued compared to the parent. This strategy can also be applied between multiple subsidiaries and the parent company.

Mean reversion plays an important role when assessing the candidates for EMN strategy. In addition, different investing themes can be used to strategize EMN strategy. Themes can range from value, momentum, earnings quality, investor sentiment, and management signaling.

What are the investment characteristics of an Equity market-neutral hedge fund strategy?

The manager's security selection skill is the main source for generating excess return over the benchmark. The return profile for EMN is stable compared to other hedge fund strategies. The strategy also has less volatility due to neutral market exposure.

The use of leverage is relatively high compared to other strategies. Having a market-neutral investment style hedges away most of the beta exposure. Thus, a high level of leverage is needed to generate meaningful returns. However, leverage can also introduce tail risk.

Rebalancing is an important aspect of this strategy. The EMN strategy uses quantitative methodologies and dynamic exposure. Thus, rebalancing is needed to maintain neutral market exposure. However, this will increase the strategy's transaction costs.

The quantitative approach to EMN differs from the discretionary approach. In a quantitative approach, trading rules are already set, specifying when and how to buy or sell. Rebalancing can be periodic or triggered based on the threshold value.

The strategy also takes a diverse position strategy compared to long short or dedicated short bias. 

For example, EMN strategies include several hundred stocks on both the long and short sides with a maximum allocation to a single company. This helps to limit a single company from adversely impacting the overall portfolio.

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