21.1 Introduction

Overview

In the previous chapter, we explored the risks and benefits of alternative investments in detail. We also learned about their structure and how liquid alternative funds and hedge funds stack up against one another and against conventional mutual funds. Moreover, the previous chapter touched upon the basics of alternative strategies, categorizing them into relative value, event-driven, and directional strategies.

What We’ll Cover

In this chapter, we will expand our knowledge by analyzing a variety of investment strategies that alternative strategy managers use within each of the categories mentioned earlier. We will also discuss performance measures that pertain to these strategies and scrutinize the comprehensive due diligence process through detailed exploration of various questions.

Key Areas to Analyze

1. Investment Strategies by Category

   • Relative Value Strategies
   • Event-Driven Strategies
   • Directional Strategies

2. Performance Measures

   • Measuring Returns and Risks
   • Comparing with Benchmarks

3. Due Diligence Process

   • Essential Questions for Evaluation

Investment Strategies

Relative Value Strategies

Relative value strategies seek to profit from the price discrepancies between related financial instruments. For instance, managers might look at arbitrage opportunities, such as equity market-neutral and convertible bond arbitrage. These strategies generally focus on minimizing market exposure and risks.

Event-Driven Strategies

Event-driven strategies focus on profiting from company-specific events, such as mergers, acquisitions, restructurings, or bankruptcies. A common approach here is merger arbitrage, where managers take positions in the companies involved in a potential merger based on the expected outcome.

Directional Strategies

Directional strategies involve taking positions based on the anticipation of market directions. This can be done through long and short positions in various markets such as equities, bonds, commodities, or currencies. Examples include global macro, emerging markets, and sector-specific long/short equity.

Performance Measures

Performance measurement is critical in evaluating the effectiveness of alternative investment strategies. Here are some key metrics used:

1. Annualized Return - Measures the average annual return of the investment.
2. Sharpe Ratio - Evaluates the risk-adjusted return by comparing portfolio returns above the risk-free rate to overall portfolio volatility.
3. Sortino Ratio - Similar to the Sharpe Ratio but uses downside deviation rather than standard deviation for risk measurement.
4. Beta - Measures the investment’s sensitivity to market movements.
5. Alpha - Represents the excess returns of the investment over its benchmark.

Here’s the formula for Sharpe Ratio:

$$ \text{Sharpe Ratio} = \frac{R_p - R_f}{\sigma_p} $$

Where:

• $R_p$ = Portfolio return
• $R_f$ = Risk-free rate
• $\sigma_p$ = Portfolio standard deviation

Due Diligence Process

Conducting due diligence is vital to the success of any investment. Here are key questions to consider:

• Background Check: What is the manager’s professional track record and educational background?
• Strategy Evaluation: What specific strategies does the manager employ, and how do they intend to achieve their investment goals?
• Performance Consistency: How consistent are the returns, and how do they compare to benchmarks over various time periods?
• Risk Management: What risk management processes are in place? How does the manager mitigate potential losses?
• Fee Structure: What are the fees associated with the investment? Are there any hidden costs?
• Legal and Regulatory Compliance: Does the investment comply with relevant legal and regulatory standards?

Key Takeaways

• In-depth understanding of alternative investment strategies such as relative value, event-driven, and directional strategies.
• Familiarity with key performance measures (e.g., Sharpe Ratio, Sortino Ratio) and their implications.
• Comprehensive due diligence processes are crucial for making sound investment decisions.

Glossary

• Relative Value: A strategy that seeks to exploit pricing inefficiencies between related financial instruments.
• Event-Driven Strategy: An investment strategy that aims to profit from company-specific events like mergers and acquisitions.
• Directional Strategy: A strategy that involves taking positions based on the prediction of market movements.
• Sharpe Ratio: A measure of risk-adjusted return.
• Sortino Ratio: A measure of the risk-adjusted return that considers downside risks only.
• Beta: A measure of sensitivity to market movements.
• Alpha: The excess return on an investment relative to the return of a benchmark index.

Frequently Asked Questions (FAQs)

Q: What is the primary goal of a relative value strategy?

A: The primary goal of a relative value strategy is to profit from price discrepancies between related financial instruments, typically aiming to minimize exposure to general market risks.

Q: How does merger arbitrage work in an event-driven strategy?

A: In merger arbitrage, managers take positions in the companies involved in a merger. They usually buy the company being acquired and short the acquiring company’s stock, hoping to gain from price convergence.

Diagram: Alternative Investment Strategies Overview

    flowchart TD
	    A[Alternative Investment Strategies] --> B[Relative Value Strategies]
	    A --> C[Event-Driven Strategies]
	    A --> D[Directional Strategies]
	    B --> E[Equity Market Neutral]
	    B --> F[Convertible Bond Arbitrage]
	    C --> G[Merger Arbitrage]
	    C --> H[Distressed Securities]
	    D --> I[Global Macro]
	    D --> J[Emerging Markets]
	    D --> K[Sector-Specific Long/Short Equity]