Russell Investments // Four hedge fund investing strategies p / 1

RUSSELL INVESTMENTS
INVESTMENT FOCUS
Under the alternative allocation umbrella, Russell includes a variety
of strategies that have low historical correlations to traditional asset
classes. In this article, I will focus on four benchmark-unaware strategies
that historically have been available through hedge funds, but are now
nding their way into the broader institutional and retail markets.
EQUITY HEDGE
OVERVIEW
An equity hedge strategy uses long and short positions, primarily in equity and equity-related
instruments. On the long side, investment managers seek gains from securities they believe to
be undervalued, to offer short-term trading opportunities or to have growth potential.
The short side is a bit more complex. Here, investment managers may seek:
1. Potential gains from securities they see as being overvalued or offering short-term trading
opportunities;
2. Reduced overall market risk; and/or
3. Potential gains from an anticipated decline in the price of a company or indexby their use
of short sales or options to hedge risk.
RATIONALE
The role of equity hedge in a hedge fund portfolio has typically been to:
Generate potential returns by taking lift with the equity markets, while limiting downside
movements;
Reduce volatility;
Provide liquidity; and
Exhibit holdings-level transparency.
Four hedge fund
investing strategies
By: Leola Ross, Ph.D., CFA, Director, Capital Markets Research
Leola Ross
STRATEGIES POTENTIAL RETURN SOURCES RISKS TO CONSIDER
Fundamental Equity market movements
Security selection skill
Tactical bets on sectors, geographies, cap size and/or style
Leverage
Tactical use of capital in response to changing market opportunities
Systematic equity market risk
Excessive leverage
Overly concentrated portfolio
Lack of stock selection skill
(stock-specic risk)
Quantitative Leverage
Tactical use of capital in response to changing market opportunities
Security selection skill
Tactical bets on sectors, geographies, cap size, style
Technical modeling skills
Excessive leverage
Mist between model specication and
current capital markets environment
Overcrowding of trades resulting from
quant model similarities across managers
Exhibit 1: Return sources and risks for equity hedge strategies
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Exhibit 2: Return sources and risks for relative value strategies
STRATEGIES POTENTIAL RETURN SOURCES RISKS TO CONSIDER
Fixed income Price/spread convergence
Curve normalization
Security selection
Leverage
Structural mispricing
Credit
Basis risk, i.e., hedging instrument and investment
instrument de-coupling; spread widening; forced
deleveraging; security-specic problems; sudden
reversals of liquidity; default risk, interest rates and
idiosyncratic credit events
Volatility
arbitrage
Return is possible from most of the greeks
(theta, vega, delta, gamma)
Implied v. realized volatility in equity options
Equity price volatility
Credit from convertible bonds
Leverage
Term structure
For volatility: Idiosyncratic risk associated with
underlying issues; complexity; high leverage
For convertible arbitrage (arb): The volatility risks,
plus credit risk (many issues are not rated by any of
the agencies); liquidity risk; co-investor risk, due to
the concentration of positions held by hedge fund
managers; short squeezes
Yield
alternatives
Long-duration yields
Credit
Interest carry
Security selection
Information asymmetries
Demographics
Illiquidity, appraisal models, some equity market risks,
credit, interest rates and macroeconomic conditions
RELATIVE VALUE
OVERVIEW
A relative value strategy is designed to
identify price discrepancies or liquidity
mismatches in securities that share a
common nancial factor, such as a specic
interest rate, index or issuer. The goal is to
capture gains and manage risk. Relative value
investments could include sovereign bonds,
interest rate swaps, convertible bonds and
equity options. Sub-strategies include xed
income and volatility.
RATIONALE
The relative value strategy provides
diversication, both to other hedge fund
strategies and to equities. Relative value is
characterized by comparatively low volatility
and market neutrality.
Some of the more challenging aspects
of relative value are its complexity,
illiquidity, non-transparency and use
of esoteric securities. All of these
characteristics inhibit the utility of standard
analytics packages in the evaluation of
portfolios. Ultimately, specialized tools
and expertise are critical to investors
understanding, evaluation and selection of
relative value portfolios.
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Exhibit 3: Return sources and risks for event-driven sub-strategies
STRATEGIES POTENTIAL RETURN SOURCES RISKS TO CONSIDER
Equity
Merger
arbitrage
Convergence of prices of acquirer and acquired upon
actuation of merger
Announced deals core
Unannounced deals more aggressive
Deals-breaking (issues with funding,
shareholder approval, target rms management,
or regulatory action)
Muted deal activity
Special
situations
Rationalization of valuations from different parts
of the capital structure often associated with a
corporate event
Idiosyncratic position risk
Event uncertainty; tail risk from events
not actuating
Illiquidity, particularly small cap deals
Activist Value creation as a result of activism realized from
sale of assets or operational turnaround
Protracted litigation
Uncooperative management teams
Miscalculation of costs
Illiquidity
Credit
Opportunistic
credit
Realization of value from oversold securities Default or sudden illiquiditycash ows dry up
Sensitivity to the economic cycle
Lack of protection within corporate structure
Poor information regarding credit ratings,
underlying assets, structure and its covenants
Some probability of large loss
Uncertain exit strategy from restructured
securities
Asset-backed Realization of Illiquidity premium from thinly
traded securities
Mispricing of imbedded options
Distressed/
high-yield
Value extraction from identication of oversold debt
securities, harvesting coupons, receiving price
appreciation once value is realized
Value creation through active participation in
restructurings
EVENT-DRIVEN
OVERVIEW
An event-driven strategy seeks gains from
market movements set into motion by specic
events. Such events include balance sheet
restructurings, mergers and acquisitions,
litigation and regulatory actions. Event-driven
investing could include corporate xed
income securities, equity-related instruments
and non-agency asset-backed and mortgage-
backed securities. Sub-strategies could target
specic opportunities in equities.
RATIONALE
Event-driven strategies are unique among
hedge fund strategies in that returns are
driven by specic events (italicized in
Exhibit 3), either within a specic corporation
or a pair of corporations, or with respect
to changes in how the market views a
corporation. These events are typically
uncorrelated to broad market conditions and
are generally associated with catalysts that
are unique to the securities in the portfolio.
Thus, event-driven sub-strategies generally
are not tied to trends or to market observers
views of securities fundamentals. Because
event probabilities dominate security
fundamentals, these funds are unlikely to get
caught in a value trap, for example.
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SUB-STRATEGY POTENTIAL RETURN SOURCES RISKS TO CONSIDER
Discretionary macro Sell discipline
Trend following
Convergence trades
Divergence trades
Causal relationships/fundamentals
Positive or negative volatility plays
Opportunism/surprise capture
Capturing rents from non-economic players
Government intervention
Choppy, directionless markets
Key-person risk
Strong bull market (the risk is that
macro-conscious managers will miss
a technical rally)
Tactical errors
Thematic errors
Systematic macro
Managed futures Trend following
Hard-coded sell discipline
Choppy, directionless markets
Key-person risk
Sudden market reversals
Black box statistical techniques
Government activity
Quantitative macro Trends in key macro fundamentals
Hard-coded sell discipline
All of the above, plus:
Revisions in economic data
Fundamentals that dont work
Changes in investor behavior
Exhibit 4: Return sources and risks for tactical trading sub-strategies
TACTICAL TRADING
OVERVIEW
Tactical trading is all about themes or
trends. Tactical trading strategies try to
pick the direction of market prices of a
particular asset, whether its a stock, a bond,
a commodity or a currency. The themes/
trends could be based on price or economic
theory, and the managers strategies usually
fall into the discretionary or quantitative sub-
categories. These strategies are implemented
through a variety of derivatives.
Tactical trading is expected to be the most
volatile of the four strategies described here.
RATIONALE
Tactical trading is a highly dynamic
strategy that behaves as a counterbalance
to market movements. In the contexts of
both equity markets and other hedge fund
strategies, tactical trading will be unique.
Tactical traders, more than any other hedge
fund managers, will seek nimbleness, sell
discipline, strong trend followingeven
following into deep troughsand brief
opportunities that others miss. The outcome
is a unique return pattern and an important
contrast to other hedge fund strategies.
Practical considerations for investors
While these four strategies will often merit
consideration for inclusion in institutional
investors portfolios, they offer distinct
return potential, risks and liquidity proles.
The appropriate solution(s) may be unique
depending on investors objectives.
Institutional investors will have many options
for accessing these strategies, such as direct
investments with specialist managers, multi-
strategy portfolios, separate accounts and
funds-of-funds solutions. As you evaluate
these options, consider an allocation and
implementation that is appropriate for your
institution and its benefactors.
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Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the
appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be
acted upon without obtaining specic legal, tax and investment advice from a licensed professional.
These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of
the document.
Where noted, the opinions expressed in this material are not necessarily those held by Russell Investment Group, its afliates or
subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and
opinions expressed herein are for general information only and are not intended to provide specic advice or recommendations for any
individual or entity.
Please remember that all investments carry some level of risk, including the potential loss of principal invested. Although steps can
be taken to help reduce risk it cannot be completely removed. They do not typically grow at an even rate of return and may experience
negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times,
unintentionally reduce returns. Although steps can be taken to help reduce risk, it cannot be completely removed.
Diversication does not assure a prot and does not protect against loss in declining markets.
In general, alternative investments involve a high degree of risk, including potential loss of principal; can be highly illiquid and can
charge higher fees than other investments. Hedge strategies and private equity investments are not subject to the same regulator
requirements as registered investment products. Hedge strategies often engage in leveraging and other speculative investment practices
that may increase the risk of investment loss.
Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future
performance and are not indicative of any specic investment.
The trademarks, service marks and copyrights related to the Russell indexes and other materials as noted are the property of their
respective owners.
Copyright Russell Investments 2013. All rights reserved. This material is proprietary and may not be reproduced, transferred or
distributed in any form without prior written permission from Russell Investments. It is delivered on an as is basis without warranty.
Russell Investment Group is a Washington USA corporation which operates through subsidiaries worldwide, including Russell
Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company.
The Russell logo is a trademark and service mark of Russell Investments.
Date of rst use: February 2013
USI-16090-03-14
For more information about these strategies,
view related Russell Research materials available
at www.russell.com or ClientLINK:
Strategy primer: Equity hedge
Strategy primer: Event-driven
Strategy primer: Relative value
Strategy primer: Tactical trading