Characteristics, Uses and Taxation of Investments - Hedge Fund Style and Structure Types
d. Relative Value Arbitrage - relative value seeks opportunity among mispriced securities with the wager of eventual price convergence. Arbitrageurs determine misvaluation by several means including fundamental, technical and quantitative analyses.
- Convertible Arbitrage - the manager looks to exploit the pricing anomaly between a convertible bond and the underlying shares into which it may be converted by purchasing the bond and selling short the stock. The desired outcome would be to gain on both the short sale as well as the long position and shield the portfolio from market volatility. Leverage is a common ingredient. Risks include event, credit, liquidity and interest rate.
- Fixed Income Arbitrage - this style is quite broad, with the common denominator of exploiting pricing differentials across global fixed income markets. Market disruptions and investor preferences often give rise to such anomalies. Examples of such strategies are, to wit: sovereign debt arbitrage, yield curve arbitrage, corporate v. treasury yield spreads, municipal bond v. treasury yield spreads and asset backed securities arbitrage. Opportunities may arise through the existence of tax loopholes, volatility differences between security types and markets and points along the yield curve. Leverage is employed to enhance returns.
- Equity Market Neutral (statistical arbitrage) - the attempt to take advantage of pricing anomalies between related equities and minimize exposure to systematic risk. This methodology is highly quantitative with the manager taking offsetting long and short positions in equal measure between what s/he perceives to be overvalued and undervalued stocks. Overlaying this approach is an eye toward insulating the portfolio from market volatility. Market neutral does not equate with long/short.
- Index Arbitrage - the manager is long securities in the index and short the index derivative in an effort to take advantage of perceived mispricings.
- Mortgage-backed Arbitrage - attempts to make money from mispricing between a mortgage-backed security with prepayment risk and a treasury security that lacks this type of risk.
b. Others - these afford investors greater opportunity for diversification, but also another layer of fees beyond those imposed by the underlying managers themselves.
- Fund of Funds (fund of hedge funds) - this strategy selects several hedge fund managers with different styles in an effort to achieve more efficient diversification resulting in greater return for less risk. The fund may allocate among several managers within a specific strategy or to several different strategies.
- Multi-Strategy Funds - an individual hedge fund's pursuit of diversification by offering several strategies utilizing a dynamic allocation among them to pursue opportunities born of changing market conditions.
2. Structure Types
- 3C-1 Fund: a limited partnership exempt from registration, this structure admits a maximum of 99 accredited investors and usually requires a sizable initial investment of several million dollars.
- 3C-7 Fund: a limited partnership as well, it admits qualified purchasers up to a maximum of 499 investors. The minimum is considerably lower, beginning at one million dollars.
- Registered, Closed-End Fund: a 1940 Act and/or 1933 Act registered fund, it allows only accredited investors, but in unlimited number and with minimums as low as $25,000.