6.1 Introduction

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The next investment strategy classification is taken from the ‘Asset management and institutional investors’ book of Basile and Ferrari. Then every single strategy was deepened in ‘Handbook of hedge funds’ of Lhabitant.

 

6.2 Directional strategies

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Directional strategies exploit market movements, both ups, and downs, while non-directional strategies exploit arbitrage techniques.

 

6.2.1 Long/short equity

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The long/short equity strategy combines long and short positions on stock securities.

 

The strategy can follow a systemic objective, building a portfolio that keeps a certain degree of directionality related to expected trends, trying to reduce the exposition to the market risk.

On the other side, the strategy can follow a specific objective, where the stock-picking ability of the manager is fundamental.

In the first case, we reason in terms of economic sectors, while in the second case, we reason in terms of single companies.

 

Long/short strategies can also be classified in two more approaches.

The first one is the valuation-based approach, of which the founding father is Benjamin Graham, professor and mentor of the famous investor Warren Buffett. This approach is based on a particular process named fundamental analysis, where the final objective is calculating the value of a company named intrinsic value. This value is then compared to the market price of that company. If the price was inferior, we would buy, if the price was superior, we would sell.

Obviously, the implicit hypotheses of this approach are two: going on in time prices of stocks have a mean-reverting behavior around the intrinsic value and markets are not efficient.

The second approach is the quantitative-based approach, which is based on the modern portfolio theory found by Markowitz. Most of the managers who adopt this approach take advantage of automatized software and, more recently, machine learning, with the final objective of optimizing their portfolio's risk-return profile.

 

6.2.2 Dedicated short or Short selling

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Different from the long/short equity, the dedicated short, or simply short selling, focuses on short positions on stock securities.

 

Managers do not very use this strategy because it is regarded as too risky. This is due to the fact that the short position is a leveraged position, which means based on financing, and could lead to losses well greater than the initial investment, in contrast to what happens in a classic long position.

 

6.2.3 Global macro

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The global macro strategy exploits expectations on changes of macroeconomic or geopolitical variables, assuming long or short positions on stocks and most likely on government bonds, currencies, and commodities, trying to exploit all the opportunities present in a specific moment on the global market.

 

It has to be observed that, in order for this strategy to be effective, the financial instruments used have to be extremely liquid. Among the most famous managers that adopted this strategy successfully, we remind George Soros.

 

6.2.4 Emerging markets

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The emerging markets strategy assumes positions on financial instruments linked to specific emerging markets.

 

The emerging market term is defined as a geographic area, usually a country that presents substantial economic growth characteristics caused by improvements in productivity, technology, and/or laws that regulate its economic activity. But emerging markets are usually characterized by strong instability caused by high public debt, political instability and/or strong inflation. These last characteristics cause high price volatility of financial instruments, which causes mispricing opportunities in the short term for managers.

 

In this strategy, approaches are declined in two subtypes based on the financial instruments used, which can be stocks, indexes, or government bonds.

 

In the first case, long positions are assumed on big companies or on indexes representing the companies of the geographic region.

 

In the second case, buy and hold positions are assumed on government bonds because they promise high returns, mainly caused by the sovereign risk, the currency risk, and the interest rate risk.

 

6.2.5 Managed futures

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The managed futures strategy focuses on future or forward contracts with underlying stocks, corporate bonds, government bonds, commodities, or currencies.

 

This strategy can be divided into two approaches: discretional and systemic trading.

In the first case, analogously to the global macro strategy, the human component exploits quantitative and, most of all, qualitative data in order to forecast price movements and assume positions on derivatives.

In the second case, an algorithm is made run via software, which dictates the timing and quantity of derivatives to be bought or sold, following precise and preordered rules.

 

The discretional approach usually requires a fundamental analysis to determine the fair value of the derivative, based on the characteristics of the underlying and the characteristics of the derivative contract.

The systemic trading approach, instead, usually requires a technical analysis, which looks for a price forecast based on past price movements.

 

6.3 Non-directional strategies

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As already mentioned, these strategies are based on arbitrage.

 

The definition of arbitrage is based on the idea of free lunch. Free lunch, in finance, is meant as the possibility to obtain a profit with minimum or zero risks, usually selling and buying securities simultaneously to exploit their price inconsistency.

 

The arbitrage is defined as an operation that presents the free lunch characteristics.

 

6.3.1 Equity market neutral

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The equity market neutral strategy consists of identifying couples of securities that historically have been moving together, of which their explanatory factors are identifiable and quantifiable.  Once a couple of securities like that has been found, it has to be kept under observation until, for irrational reasons or for a market flaw, the two prices diverge temporarily one from the other. This divergence is quantified by the distance function; once the distance function passes a defined minimum threshold, we assume a long position on the undervalued security and contextually a short position on the overvalued security.

 

The result of this operation is a double-dip profit at the moment when the two securities will start converging back. Clearly, the manager would opt for a stop loss at the moment when the distance function passes a determined threshold in order to contain losses.

 

The most interesting part of this operation is the fact that the systematic risk is eliminated since we have simultaneously sold and bought two securities strongly correlated. If the choice of the securities and their weight were correct, in case of general market spikes, the long position would appreciate, and the short position would depreciate, leading to a total null result. The same in the case of general market falls, obtaining an actual portfolio with positive alpha and null beta.

 

This strategy evolved from looking for couples of securities to looking for groups of securities of which their prices move in a correlated way. In this case, when a discrepancy occurs, we have to buy the most undervalued securities and sell the most overvalued securities.

 

Finally, we can observe that this strategy is appliable not only to stocks but to any type of financial instruments that respect the correlation requirements.

 

6.3.2 Fixed income arbitrage

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The fixed income arbitrage strategy exploits pricing anomalies in fixed income securities like government bonds and corporate bonds. There are different approaches to this strategy. Here we show only two common ones.

 

The Treasuries stripping approach consists of separating the cash flows of a coupon bond and sell them separately as if they were zero coupon bonds. Clearly, this approach is profitable when the misprice is such that it allows selling the zero-coupon bonds at a higher total price than what was paid for the coupon bond.

 

The Yield-curve arbitrage approach consists of buying and selling simultaneously bond securities placed on different points of the yield-curve, which means assuming long and short positions on bond securities that have different maturities from the same issuer. This approach aims to obtain a profit from misprices on the yield-curve due to the market's irrational interest in specific maturities.

 

6.3.3 Convertible arbitrage

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The convertible arbitrage strategy exploits a situation of mispricing between convertible bonds and their underlying stocks.

 

Practically, the idea is based on the situation where the convertible bond price is too low, given the underlying stock price.

 

Thus, instead of simply buying the convertible bond and waiting for the realignment of its price, which involves a series of risks, we assume three different positions to cover these risks: we assume a long position on the convertible bond, but simultaneously we assume a short position on the underlying stock to cover the price risk of the stock, and we also buy an interest rate swap derivative to cover the interest rate risk of the convertible bond. Once we have assumed these three positions, we have just to wait for the misprice to disappear.

 

6.3.4 Event driven

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The event driven strategy exploits stock price dynamics, of a company or a group of companies, after given events.

 

A particular type of event driven strategy that is common is the Merger arbitrage approach, which exploits stock price dynamics of a target company after public announcements about a future merger or acquisition have been made.

 

The pivotal concept of this arbitrage is the arbitrage spread, defined as the spread between the fixed price offered by the bidder company and the market price of the target company. Reminding that the offered price is always higher than the market price.

 

Following the announcement, we have to consider that there will be two scenarios. The transaction is successful, so the arbitrage spread tends to zero, which means that the market price of the target tends to the offered price. The transaction is unsuccessful, so the arbitrage spread becomes wider caused by the fall of the target company’s price.

 

What happens in the case of a successful transaction is explained as follows. Traders perceive the imminent merger or acquisition and start buying the stocks of the target company, willing to sell them back in the future to the bidder company, making the price hike, which will converge to the offered price, as already stated. Arbitragers are just capturing these dynamics of the arbitrage spread.

 

In the case of a cash tender offer, the long position on the target company implies a market risk, which means that if the market fell before the conclusion of the transaction, the stock price would fall with it, compromising the final arbitrage profit. Thus, arbitragers have to cover themselves (even if only partially). Contextually to assuming a long position on the stock, they also assume a short position on an index that is correlated as much as possible.

 

In the case of a stock-for-stock offer, the offered price is not fixed anymore, but it changes as the bidder company’s market price changes. In this case, the market price of the target company does not tend to a fixed value anymore but to a variable value that changes over time. In this case, we have to think about an arbitrage spread that still shrinks over time but in relative terms. Thus, the operation that has to be executed in this case is to assume the same long position on the target company and a short position on the bidder company - instead of on an index. Doing so, we capture the arbitrage spread profit and we also cover ourselves from absolute variations of the two stocks, which means no market risk. What really matters is only the relative variation between the two prices, which is indeed the shrinkage of the arbitrage spread.

 

6.3.5 Distressed securities

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The distressed securities strategy exploits misprices on companies that are under economic or financial stress but with high probabilities of making it through the crisis, assuming long positions on their stocks and bonds. In simple terms, these companies were excessively penalized by the market.

 

 

6.4 Other strategies

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As follows, we will define two other interesting non-directional investment strategies that are not part of the previous classification.

 

6.4.1 Weather derivatives and Cat bonds

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Weather derivatives and cat bonds have been consolidating their status on the international financial markets. Despite these two financial instruments' insurance nature, as defined in chapter 3, they have been alluring many arbitragers to try exploiting the mispricing opportunities present on these new growing markets before these opportunities will vanish.

 

6.4.2 Cross-listing arbitrage and Dual-listing arbitrage

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The cross-listing arbitrage strategy consists of exploiting a misprice between stocks of the same public company exchanged in different national stock exchanges, considering the currency exchange rate.

 

This arbitrage can be implemented in two ways. In the first case, we buy the undervalued stock exchanged in market A, and we convert it directly into the overvalued stock exchanged in market B to sell it, but legal and transaction costs could erode the arbitrage margin completely.

 

In the second case, instead, less expensive, we assume a long position on the undervalued stock and a short position on the overvalued stock.

 

The dual-listing arbitrage consists of exploiting a misprice between stocks of two different public companies exchanged in the same market, but these two companies are the result of a previous merger where it was decided to keep the two legal entities distinct for fiscal and/or legal (antitrust) reasons.

 

Since these two companies, in fact, represent a single company because they decided to combine their operations and their cashflows, keeping an identical dividend policy per stock, they should have the same price.

 

In the case of mispricing, it is possible to exploit the situation by assuming a long position on the undervalued stock and a short position on the overvalued stock.