What Is a Relative Value Fund?
A common strategy when managing relative value funds is called pairs trading, which consists of initiating a long and short position for a pair of assets that are highly correlated. In some cases, relative value funds can generate risk-free profits through the process of buying and selling the two different securities at the same time, which is called arbitrage.
- A relative value fund is an actively managed investment vehicle that seeks to exploit mispricings of related securities.
- Whether or not a security is undervalued or overvalued is speculative and investors will attempt to determine this using different approaches, including a common strategy called reversion to the mean.
- Pair trading is a common strategy of relative value funds where a long and short position is initiated for a pair of assets that are highly correlated.
Understanding Relative Value Funds
Whereas most investment funds evaluate investment candidates separately, relative value funds assess candidates by comparing their prices to those of related assets, or benchmarks. For instance, a relative value fund might evaluate the attractiveness of a technology company by comparing its price and fundamentals relative to other companies in its industry, whereas most investors would likely evaluate the company on its individual merits. The goal of relative value funds is to identify assets that are mispriced in relation to each other.
Relative value funds are typically hedge funds, which often seek to use leverage to amplify their returns. Such funds will use margin trading to take long positions on securities they consider undervalued, while at the same time taking short positions on related securities they consider overvalued.
The question of whether a security is undervalued or overvalued is speculative, and investors will attempt to determine this using a variety of different approaches. A common strategy is to rely on reversion to the mean.
In other words, investors will often assume that, in the long run, prices will revert toward their long-term historical averages. Therefore, if a given asset is expensive relative to its historical level, it will be viewed as a candidate for short selling. Those trading below historical levels, on the other hand, will be viewed as long candidates.
The most commonly used relative value strategy is pairs trading, though this approach is implemented in a range of ways by investors. Some investors will seek to exploit different valuations between securities that are closely related to each other, such as competitors within the oil and gas industry that are included in the S&P 500 Index.
Other investors might adopt a macroeconomic approach, seeking to exploit mispricings between stocks, bonds, options, and currency futures relative to the performance of the countries where they are in operation.
This latter approach is still considered pairs trading, but identifying the relevant correlative elements and structuring the required transactions is much more complex in this scenario than in the more common scenario of initiating long and short positions in two related assets.
Real World Example of a Relative Value Fund
Suppose you are the manager of a relative value fund that is seeking to exploit mispricings between correlated securities. In implementing this strategy, your firm uses a range of approaches, which vary with respect to their risk-reward profile.
On the low-risk end of the spectrum are true arbitrage opportunities. Although these are rare, they offer the opportunity to profit with practically no risk and are therefore your firm's preferred type of activity. An example of this is that you are occasionally able to simultaneously buy and sell convertible debt instruments along with their underlying stock. In doing this, you are effectively exploiting temporary discrepancies in their valuations.
More often, your trades are more speculative. For instance, you often short sell securities which are overvalued relative to their peer group, while taking a long approach with their undervalued peers. By making this determination, you are relying on the assumption that the past will repeat itself, and in the long-run, prices will revert toward their historical mean or average. Because there is no way to know when this mean reversion will occur, it is possible for these inexplicable mispricings to persist for long periods of time. This risk is compounded even more when leverage is involved because of the cost of interest and the risk of margin calls.