Alternative Investments: Hedge Funds

Event -driven funds use relative value plays, going long and short in related securities, but the relationship they discover and exploit is a 'special situation', not a historical price pattern. The special situation is usually a merger, a restructuring or a bankruptcy. The two classic strategies are merger arbitrage and distressed securities.

Merger arbitrageurs usually go long in the company being acquired, anticipating a stock price rise, and short the stock of the predator company, anticipating a stock price fall. The investment strategy is the same for distressed securities, but here the companies are facing bankruptcy, so the possibility of an acquisition increases.

These strategies have low correlations to the traditional market indices, lower in fact, on average, than relative value funds because they are identifying specific events, rather than trends. However, they are not immune to market factors. (Pairs are not picked on the basis of any historical correlation, whatever the market is doing). And there are additional risk factors - . the risk that the deal will not be completed; if, for example, a third party enters with a hostile bid, or the regulators step in, or if there is a walk-away clause in deal documentation.

In spite of its higher risk profile, merger arbitrage has gone from strength to strength in recent years. This largely reflects the amount of M&A activity in the US and Europe, particularly following the introduction of the euro. It is important for investors to remember, however, that merger arbitrage is limited by the number of deals taking place at any one time.

Distressed securities strategies, meanwhile, had their heyday in the early 1990s on the back of LBO activity in the 1980s. More recently, particularly after the Russian debt crisis of 1998, investors have become wary of holding paper that is not investment grade.

Global macro funds

Macro funds engage in tactical, directional trades. They are speculative funds which tend to look across all markets (currencies, commodities, equities, fixed income and derivatives ) for opportunities. George Soros' Quantum Fund was the best known global macro player, most famously betting against the position of sterling in the European Exchange Rate Mechanism in 1992, a bet that earned him an estimated US$1 billion.

Instead of neutralising market risk by trading relative value, or reducing market risk by taking long and short positions in a single market, Macro Funds tend to go long or short, focusing on one-way, directional plays which take on 100% market risk. Consequently, these strategies are the most highly correlated to the main market indices.

A Macro Fund also tends to use leverage as an end in itself - to increase the risk/return profile of a single position rather than to achieve a partially offsetting portfolio (as long-short funds do) or to spread-trade (as relative value funds do). Their attraction to investors reflects the potentially high returns. Macro managers are usually highly secretive when it comes to keeping their trading strategies under wraps, so it can be difficult for investors to find out how these managers manage risk within their portfolios.