Relative Value Hedge Funds

Total hedge fund industry capital rose to surpass the $4 trillion milestone to begin 2022, representing an increase of over $400 billion from the start of 2021, according to HFR.

Notably, the data shows relative value arbitrage strategies led all main alternative investment strategies with $15 billion of new allocations for the fiscal year 2021.

In times of heightened volatility, investors are attracted to this strategy as it can help insulate portfolios from market uncertainty and generate alpha while decreasing portfolio volatility.

The relative value hedge fund strategy is predicated on the realization of a valuation discrepancy in the relationship between multiple securities. In doing so, the strategy seeks to take advantage of price differentials by simultaneously buying and selling different securities.

To implement this strategy, managers will often employ fundamental and quantitative methods to establish their investment theses and identify investment opportunities.

Relative value managers often trade across equities, fixed income, commodities, currencies, and derivatives in their portfolios.

Through these methods and securities, relative value hedge funds aim to provide isolated returns across financial markets where they can realize an attractive spread between two or more securities.

The objective of relative value hedge funds is to generate an uncorrelated return compared to the broader market. This objective is largely achieved by capturing the relative value spread when two related securities diverge in price.

This divergence can occur when related securities move in the opposite direction, or when they move in the same direction, it is then the magnitude of change that would create a relative value opportunity.

In general, managers first identify securities that have exhibited a consistent and repeatable relationship over time. Once this relationship has broken or deviated from conventional behavior, the manager will seek to exploit the divergence as a return opportunity.

When the relative value manager believes that certain metrics such as the price of one security relative to another has exceeded historical ranges or that prices will eventually mean revert, the manager will buy one security and short the other. When the prices converge, the manager closes the trade in hopes of locking in a profit.

There are many ways to apply a relative value approach to financial markets. One approach may involve trading multiple securities within the capital structure of a single issuer.

For instance, if a company reports disappointing earnings, it is possible to see an immediate and precipitous drop in its stock price. However, as it relates to the company’s bond price, given positioning in a company’s capital structure, similar information may not be as impactful. This is because this type of information flow is less impactful on securities at the top of the capital structure (e.g., senior secured debt) relative to securities at the bottom (e.g., equities).

What does this mean for a relative value hedge fund strategy?

A manager may take advantage of this market dynamic and capture the pricing differential by purchasing the equity shares and shorting the bond in hopes that there was an overreaction in the equity price and an underreaction in the bond price.

A second method might take advantage of price differentials between different issuers. The issuers might compete in the same industry or simply might demonstrate a stable and consistent relationship over time. Relative value hedge funds will examine this relationship to identify when there is a break in character.

Take Company X, for example. Over the past 5 years, Company X traded at an average price to earnings multiple (“P/E”) of 15x, and its main competitor Company Y traded at an average P/E of 20x.

These historical prices indicate a PE ratio¹ of ~1.33x between Company X and Company Y, meaning that based on the last 5 years, the PE ratio of Company Y has been 1.33x more than Company X.

If this PE spread between Company X and Y increases from 1.33x to 3x, among other factors, the manager may find that Company Y is overpriced relative to Company X based on the increase in spread and could establish a trade to exploit this mispricing.

To execute this trade, the manager will purchase shares of Company X and short shares of Company Y in anticipation of the spread contracting to the historical range.

1. The PE ratio is calculatsed by taking the PE multiple of Company Y and dividing by the PE multiple of Company X [20x/15x]

Because there are many markets and securities available to relative value managers, the types of securities in which they transact will contribute in part to the types of risk borne by the strategy.

Some strategies focus on illiquid fixed income securities, which represent a higher liquidity risk. However, despite the strategy focus, stressed market environments can impact all securities and thus should be monitored closely by the manager.

With macro trades, managers are subject to exogenous events such as geopolitics and natural disasters. Such events must be incorporated into the analysis as they can bring considerable stress to the market and the strategy.

Furthermore, it is never certain that two related securities that have diverged in price, even significantly, will either mean revert, or more importantly, mean revert within a desired timeframe.

Timely and Accurate Decisions

The strategy requires significant expertise as the manager must be able to make timely decisions and accurately understand the relationship between the securities.

Timely decisions are critical because other market participants could exploit the spread when the alpha opportunity is at its greatest and diminish the return opportunity. In addition to being timely, the manager needs to understand the reason behind the pricing discrepancy and accurately forecast the future spread among the traded securities.

For example, the manager could execute the trade in a timely manner but lose out on the return if the spread moves in the opposite direction of their forecast.

Leverage

Given this risk, it is important that managers size their trades appropriately and carefully employ the use of leverage. Leveraged investment strategies are often used when relative value hedge funds want to magnify smaller pricing discrepancies through borrowing money (margin) or using options.

However, the use of leverage is very risky for several reasons, including the possibility to lose more money than was initially invested. A manager may also be required to sell securities when falling prices reduce the value of the securities.

Additionally, the use of options carries no guarantees, with option holders capable of losing the entire amount of premium paid and option writers exposed to unlimited potential losses.

Investors bracing for heightened market volatility are seeking to insulate their portfolios by increasing capital allocations to relative value hedge funds for their uncorrelated, idiosyncratic risk/return profile.

The success of the strategy is dependent on a manager’s ability to correctly identify and capture the spread between two related securities.

Managers accomplish this by using various methods and securities to isolate attractive opportunities across financial markets where they can realize an attractive spread.

It is never certain, however, that two dislocated securities will converge in price, emphasizing the importance of portfolio construction, timely and accurate decisions, and the appropriate use of leverage.

Alternative investing is not without its unique risks and complexities, which makes partnering with the right alternative investment platform paramount.

Sources:
Hedge Fund Research. HFR Hedge Fund Strategy Definitions – Relative Value
Barclay Hedge, 2012. Understanding Relative-Value Arbitrage
The Business Professor. Capital Structure Arbitrage – Explained
U.S. Securities and Exchange Commission, 2021. Leveraged Investing Strategies
HFR. Q421_HFR.pdf