Alternative Investment Strategies
Objectives
-
Explain the Variance in Alternative Strategies: Understand the workings of various types of alternative strategies, including those in the relative value, event-driven, and directional strategy classifications.
-
Identify Strategies in Alternative Mutual Funds: Recognize the strategies most likely to be used in alternative mutual funds.
Categories of Alternative Investment Strategies
Alternative investment strategies can be divided into three broad categories:
- Relative Value Strategies
- Event-Driven Strategies
- Directional Strategies
These categories are listed in order of increasing expected return and risk.
Relative Value Strategies
Relative value strategies aim to profit by leveraging inefficiencies or discrepancies in the pricing of related stocks, bonds, or derivatives. Funds employing these strategies generally have low or no exposure to the underlying market direction.
| Relative Value Strategies |
| Equity market-neutral |
| Convertible arbitrage |
| Fixed-income arbitrage |
Key Characteristics:
- Equity Market-Neutral: Seeks profits through balanced positions between long and short in equities, reducing exposure to market movements.
- Convertible Arbitrage: Involves taking long positions in convertible securities and short positions in underlying equity, capitalizing on pricing inefficiencies.
- Fixed-Income Arbitrage: Focuses on exploiting small price differences in bonds, aiming to capitalize on pricing inefficiencies in the bond markets.
Event-Driven Strategies
Event-driven strategies seek to exploit inefficiencies created by specific events affecting semi-prime companies such as mergers, acquisitions, stock splits, and buybacks. These strategies demonstrate medium exposure to the underlying market direction.
| Event-Driven Strategies |
| Merger or risk arbitrage |
| Distressed securities |
| High-yield bonds |
Key Characteristics:
- Merger or Risk Arbitrage: Profits from price discrepancies between the current market price of a target company and the final purchase price post-merger.
- Distressed Securities: Investments in companies undergoing restructuring, bankruptcy or operational challenges with the potential for significant value appreciation.
- High-Yield Bonds: Investing in bonds with lower credit ratings but higher yields, considered to expose investors to credit risk and interest rate risk.
Directional Strategies
Directional strategies involve placing bets on predicted movements in market prices of equity securities, debt securities, foreign currencies, and commodities. These strategies generally exhibit high exposure to trends in the underlying market.
| Directional Strategies |
| Long/short equity |
| Global macro |
| Emerging markets |
| Dedicated short bias |
| Managed futures |
Key Characteristics:
- Long/Short Equity: Takes long and short positions to exploit anticipated individual stock price moves, hedging against market risk.
- Global Macro: Investments based on overarching macroeconomic principles and global economic indicators.
- Emerging Markets: Focused on investing in securities from developing markets expected to exhibit high growth potential.
- Dedicated Short Bias: Emphasis on short selling to profit from declining securities.
- Managed Futures: Employs trading strategies involving futures contracts across various asset classes, managed by professional portfolio managers.
Table 21.1: Major Alternative Strategy Fund Categories
| Capacity |
Low Exposure to Market Direction |
Medium Exposure to Market Direction |
High Exposure to Market Direction |
| Funds |
Equity Market-Neutral |
Merger or Risk Arbitrage |
Long/Short Equity |
| Convertible Arbitrage |
Distressed Securities |
Global Macro |
|
| Fixed-Income Arbitrage |
High-Yield Bonds |
Emerging Markets |
|
|
|
Dedicated Short Bias |
|
|
|
Managed Futures |
|
Frequently Asked Questions (FAQs)
Q1: What is the primary objective of relative value strategies?
A1: The primary objective is to profit by exploiting price inefficiencies between related financial instruments while maintaining low or no exposure to overall market direction.
Q2: Which types of events do event-driven strategies focus on?
A2: Event-driven strategies focus on corporate events such as mergers, acquisitions, bankruptcies, restructurings, stock splits, and share buybacks.
Q3: What risk factors are associated with directional strategies?
A3: Directional strategies are highly exposed to market trends and movements, making them subject to market risk, prices changes influenced by global economic factors, political situations, and market volatility.
Key Takeaways
- Alternative Investment Strategies: Divided into relative value, event-driven, and directional strategy classes, targeting expected returns with varying risk levels.
- Exposure Levels: Differ by strategy type - relative value strategies typically show low exposure, event-driven strategies medium exposure, and directional strategies high exposure to market trends.
- Diversification and Complexity: Each strategy offers a unique approach for diversification and involves complex dynamics in asset performance and market behavior.
Glossary
- Price Inefficiencies: Occurs when financial instruments don’t accurately represent their true market value, providing potential arbitrage opportunities.
- Merger Arbitrage: Strategy involving purchasing target company stock pre-merger and betting on successful completion for profit.
- Managed Futures: Investment strategy involving derivatives such as futures contracts, overseen by professional managers based on market predictions.
By understanding these various strategies, investors can make more informed decisions based on their risk tolerance, market perspective, and long-term financial objectives.
📚✨ Quiz Time! ✨📚
## Which of the following strategies seeks to profit by exploiting inefficiencies in the pricing of related stocks, bonds, or derivatives?
- [ ] Event-driven strategies
- [ ] Directional strategies
- [x] Relative value strategies
- [ ] Market-timing strategies
> **Explanation:** Relative value strategies attempt to profit by exploiting inefficiencies or differences in the pricing of related stocks, bonds, or derivatives. These strategies generally have low or no exposure to the underlying market direction.
## What is the primary goal of event-driven strategies?
- [x] To profit from unique corporate structure events such as mergers, acquisitions, and stock splits
- [ ] To take advantage of long and short positions in equity markets
- [ ] To employ quantitative models for market predictions
- [ ] To profit by betting on overall market movements
> **Explanation:** Event-driven strategies seek to profit from unique corporate events such as mergers, acquisitions, stock splits, and buybacks, and they typically have medium exposure to the underlying market direction.
## What type of strategies have the highest exposure to trends in the underlying market?
- [ ] Relative value strategies
- [ ] Event-driven strategies
- [x] Directional strategies
- [ ] Market-neutral strategies
> **Explanation:** Directional strategies bet on anticipated movements in the market prices of various assets and have high exposure to trends in the underlying market.
## Which category does convertible arbitrage fall into?
- [x] Relative value strategies
- [ ] Event-driven strategies
- [ ] Directional strategies
- [ ] Credit strategies
> **Explanation:** Convertible arbitrage is a type of relative value strategy that seeks to take advantage of pricing inefficiencies between convertible securities and the underlying stock or bond.
## Long/short equity strategies fall under which major alternative strategy category?
- [ ] Relative value strategies
- [ ] Event-driven strategies
- [x] Directional strategies
- [ ] Arbitrage strategies
> **Explanation:** Long/short equity strategies involve taking long positions in undervalued stocks and short positions in overvalued stocks. These strategies fall under the directional strategies category and have high exposure to market trends.
## What are the expected return and risk for relative value strategies compared to other alternative investment strategies?
- [ ] High expected return and high risk
- [ ] Medium expected return and medium risk
- [x] Low expected return and low risk
- [ ] High expected return and medium risk
> **Explanation:** Relative value strategies generally have low expected returns and low risk compared to event-driven and directional strategies.
## Which strategy might involve taking advantage of corporate events like mergers and acquisitions?
- [x] Merger or risk arbitrage
- [ ] Global macro
- [ ] Convertible arbitrage
- [ ] Managed futures
> **Explanation:** Event-driven strategies like merger or risk arbitrage seek to profit from specific corporate events such as mergers and acquisitions.
## How much exposure to underlying market direction do event-driven strategies have?
- [ ] High exposure
- [ ] Low exposure
- [x] Medium exposure
- [ ] No exposure
> **Explanation:** Event-driven strategies have medium exposure to the underlying market direction, as they are influenced by corporate events that can vary in their impact on market prices.
## Fixed-income arbitrage can be classified under which category of alternative strategies?
- [ ] Directional strategies
- [ ] Event-driven strategies
- [x] Relative value strategies
- [ ] Directional and event-driven strategies
> **Explanation:** Fixed-income arbitrage is a relative value strategy that takes advantage of pricing discrepancies between related fixed-income securities.
## Which alternative strategy is primarily focused on global economic trends and macroeconomic policies?
- [ ] Equity market-neutral
- [x] Global macro
- [ ] Convertible arbitrage
- [ ] Merger or risk arbitrage
> **Explanation:** Global macro strategies focus on exploiting opportunities driven by global economic trends and macroeconomic policies and fall under the directional strategies category.
In this section
-
21.2.1 Relative Value Strategies
Comprehensive guide to understanding relative value strategies including equity market-neutral strategies, convertible arbitrage, and fixed-income arbitrage. Key concepts, examples, FAQs, and detailed methodologies are explored for effective trading.
-
21.2.2 Event-driven Strategies
A comprehensive guide detailing event-driven strategies including merger (risk arbitrage) strategies, high-yield bond strategies, and distressed securities strategies. Learn how these unique corporate structures can generate profit through strategic investments.
-
21.2.3 Directional Strategies
In-depth exploration of directional investment strategies including long/short equity, global macro, emerging markets, dedicated short bias, and managed futures strategies. This chapter covers essential concepts, examples, mathematical calculations, and advantages and considerations.
-
21.2.4 Multi-strategy Funds
Understand the concept, benefits, and risks of multi-strategy funds in the context of Canadian securities. Explore the differences between multi-strategy funds and fund-of-funds, including diversification benefits and management fee considerations.
-
21.2.5 Leveraged ETF Strategy
Comprehensive guide on Leveraged ETF Strategy including investment strategies, risk measures, due diligence, and suitability for investors.