Investment Strategies of Hedge Funds

Filippo Stefanini is the Head of Research at Eurizon AI SGR where he is responsible for analysing, selecting and monitoring hedge funds and newcits funds.  Eurizon AI SGR SpA is the alternative investment company of the banking group Intesa San Paolo and specialises in managing funds of hedge funds. He has been a lecturer in Risk Management at the University of Bergamo (Italy) since 2007. Filippo Stefanini was  the Deputy Chief Investment Officer and Head of Asset Allocation at Aletti Gestielle Alternative SGR from 2001 to mid 2008. He previously worked as a consultant for Accenture in the Asset Management and Investment Banking areas. Filippo is the author of “Investment Strategies of Hedge Funds” and “Newcits: Investing in UCITS Compliant Hedge Funds”, both published by John Wiley & Sons. He has also co-authored some Italian language books published by Il Sole 24 Ore entitled “I fondi newcits”, “Hedge Funds: strategie di investimento” and “Hedge Funds: Investire per generare rendimenti assoluti”.

• Foreword xiPreface xiiiAcknowledgments xviiAbout the Author xix1 A Few Initial Remarks 11.1 What is a hedge fund? 11.2 History of hedge funds 21.3 Proprietary trading 41.4 The growth of the hedge fund industry 41.5 Main characteristics of the current industry 61.6 Capacity 81.7 Commissions 81.8 Industry performance overview 91.9 The hedge fund manager 121.10 Alpha and beta 121.11 Investment strategies 131.12 Explorers and frontiers 161.13 SEC’s vigilance 161.14 Considerations on performance sustainability 161.15 Capacity and performance sustainability 171.16 Ability or chance? 171.17 The importance of avoiding losses 181.18 Decreasing returns with longer investment horizons 191.19 Business case: A hedge fund start-up 192 Arbitrage 212.1 The transaction costs barrier 222.2 ADR arbitrage 232.3 Arbitrage between off-the-run and on-the-run thirty-year Treasury Bonds 243 Short Selling 273.1 A brief history of short selling 273.2 What is short selling? 303.3 A simplified example of short selling on US markets 313.4 Who lends securities for short selling? 323.5 Regulations governing short selling 333.6 The risks of short selling 343.7 Short interest and short interest ratio 353.8 Wall Street’s alter ego 363.9 Stock picking in short selling 373.10 The art of contrary thinking 413.11 Measuring the strategy’s historical performance 423.12 Conclusions 454 Long/Short Equity 474.1 History of the first hedge fund 484.2 Market exposure 484.3 Management styles 524.4 Specialized long/short equity funds 554.4.1 Long/short equity technology-media-telecommunication (TMT) 564.4.2 Long/short equity biotech 574.4.3 Long/short equity gold 584.4.4 Long/short equity on emerging markets 584.5 Share class arbitrage 624.6 Pairs trading 624.7 Covered call and covered put options sale 644.8 Strategy’s historical performance analysis 654.9 Equity market neutral 694.9.1 Equity market neutral strategy’s historical performance analysis 705 Merger Arbitrage 755.1 A brief history of M&A 765.2 Strategy description 825.3 Risk associated with the outcome of an extraordinary corporate event 835.4 Types of mergers and acquisitions 865.4.1 Cash mergers or tender offers 865.4.2 Stock swap mergers or stock-for-stock mergers 875.4.3 Stock swap mergers with a collar 895.4.4 Multiple bidder situations 905.4.5 Leveraged buyouts and hostile takeovers 905.4.6 Spin-offs 925.5 Risk management 925.6 Strategy’s historical performance analysis 935.7 Conclusions 966 Convertible Bond Arbitrage 996.1 Why issue a convertible bond? 1016.2 A brief history of convertible bonds 1016.3 The convertible bond market 1026.4 Definitions 1066.5 Quantitative models to value convertible bonds 1076.5.1 Analytical models 1086.5.2 Numerical models 1096.6 Implied volatility and historical volatility 1106.6.1 Credit spreads, implied volatility and risk appetite 1106.7 Convertible bond arbitrage 1106.7.1 Cash-flow arbitrage 1116.7.2 Volatility trading 1136.7.3 Gamma trading 1176.7.4 Credit arbitrage 1206.7.5 Skewed arbitrage 1246.7.6 Carry trade 1246.7.7 Refinancing plays 1266.7.8 Late stage restructuring plays 1266.7.9 Multi-strategy 1266.8 Mandatory convertibles 1266.9 Strategy’s historical performance analysis 1286.10 Risk control 1326.11 Conclusions 1337 Fixed Income Arbitrage 1357.1 Issuance driven arbitrage or snap trade 1377.2 Yield curve arbitrage 1377.3 Intermarket spread trading 1407.4 Futures basis trading or basis trading 1407.5 Swap spread trading 1407.6 Capital structure arbitrage 1417.7 Long/short credit or credit pair trading 1447.8 Carry trade 1487.9 Break-even inflation trades 1487.10 Cross-currency relative value trade 1497.11 Treasuries over eurodollars (TED) spread or international credit spread 1517.12 Leveraged loans 1517.13 Strategy’s historical performance analysis 1537.14 Conclusions 1578 Strategies on CDOs 1598.1 A brief history of CDOs 1628.2 Hedge fund investment strategies 1638.2.1 Carry trade 1638.2.2 Long/short structured credit 1648.2.3 Correlation trade 1648.3 Conclusions 1669 Mortgage-Backed Securities Arbitrage 1679.1 A brief history of mortgage-backed securities 1679.2 Originators of mortgage-backed securities 1679.3 The industry of mortgage-backed securities 1699.3.1 Pass-through securities 1699.3.2 Collateralized mortgage obligations 1709.3.3 “Interest Only” securities and “Principal Only” securities 1709.4 The sensitivity of mortgage-backed securities to interest rates 1719.5 Arbitrage on mortgage-backed securities 1739.6 Risk factors 1749.7 Strategy’s historical performance analysis 1749.8 Conclusions 17810 Distressed Securities 17910.1 A brief history of distressed securities 18010.2 The distressed debt market 18110.3 Bankruptcy laws 18610.4 Strategy description 18710.4.1 Securities involved 18710.4.2 Investment thesis 19210.4.3 The valuation process 19410.4.4 Hedging techniques 19510.5 Risks 19510.6 A brief consideration of the directional nature of distressed securities hedge funds 19610.7 Trade claims 19810.8 Strategy’s historical performance analysis 20210.9 Conclusions 20611 Event Driven or Special Situations 20711.1 Activist investors 20811.2 Strategy’s historical performance analysis 21112 Multi-Strategy 21712.1 Multi-strategy funds 21712.2 Strategy’s historical performance analysis 21713 Managed Futures 22313.1 What is a futures contract? 22413.2 A brief history of managed futures 22413.3 Managed futures strategy 22513.4 “Do storks deliver babies?” and the predictability of financial time series 23313.5 Strategy’s historical performance analysis 23313.6 Conclusions 23814 Global Macro 23914.1 A brief history of macro funds 24014.2 Investment strategies adopted 24214.3 The characteristics shared by great traders 24214.4 The legs of a trade 24314.5 The theory of reflexivity by George Soros 24814.6 Debt emerging markets 24914.7 Strategy’s historical performance 25514.8 Conclusions 25815 Other Strategies 25915.1 Holding company arbitrage 25915.2 Closed-end fund arbitrage 26015.3 Statistical arbitrage 26115.4 Index arbitrage 26215.5 Volatility trading 26215.5.1 Option trading 26315.5.2 Delta hedging 26415.5.3 Variance swaps 26415.5.4 Other instruments 26415.6 Split-strike conversion 26515.7 Lending 26515.8 PIPEs or Regulation D 26815.9 Real estate 27015.10 Natural resources 27015.11 Energy trading 27415.12 Natural events 27516 Hedge Fund Performance Analysis 27916.1 Risks inherent in hedge fund investments 27916.2 Hedge fund strategies indices 28116.2.1 Benchmarking 28216.3 Statistical analysis of indices 28316.4 Value at risk 28716.5 Statistical analysis of data from the LIPPER TASS database 28917 Conclusions 291Bibliography 295Index 299

"This is a very good place to investigate the reality of hedge funds." (Pensions World, October 2007)