What is a Relative Value Fund
A relative value fund is a managed investment vehicle that seeks to exploit differences in the price or rate of the same or similar securities. Relative value funds usually exploit the pricing discrepancies by buying one security and selling the other in a form of pairs trading. Relative value funds tend to be hedge funds, as they trade on gaps rather than on the price of a specific security alone, and they can garner more profit by using leverage when an arbitrage opportunity is identified. A relative value fund may take positions if the gap between prices or rates is considered to have reached its peak and is thus expected to shrink, or if similar securities are experiencing price changes. Sometimes the term is hyphenated — "relative-value fund."
BREAKING DOWN Relative Value Fund
Relative value funds are essentially looking for assets that are mispriced relative to each other. A relative value fund manager will usually take long positions on securities considered undervalued, while taking short positions on securities considered overvalued. Relative value fund managers determine what they consider normal differences in prices or rates by examining historical price and market information. Once the fund manager identifies a pricing dynamic that appears out of sync with historical trends, he or she will take positions that exploit that pricing gap until the normal state is reached.
Relative Value Funds and Relative Value Strategies
Pairs trading is the most widely known relative value strategy that these funds use. The focus of pairs trading can be extremely tight or surprisingly broad. For example, a tightly focused relative value strategy may look at the relationship between S&P 500-listed stocks and bonds, watching for arbitrage opportunities. A more macro focused relative value fund might use a combination of stocks, bonds, options and currency futures to segment portions of the S&P 500 against the performance of the countries they primarily operate in. This more integrated approach can still technically be called a pairs trade, but the complexity of actually identifying the correlation and structuring the trade goes far beyond simply watching two correlated assets and going short one and long the other. Simply put, relative value strategies and the trades they suggest can be as simple or complex as the correlation the fund manager is seeking to exploit.
The Approach of Relative Value Funds
Relative value funds may also have a specific approach that dictates the type of trades they make. These approaches will generally fall into the two large buckets of fundamental analysis and technical analysis. The fundamental relative value fund will be more focused on the fundamental indicators for assets, whereas a technical relative value fund will care more about the charts, moving averages and so on. Regardless of the approach, most relative value funds dabble in statistical modeling to help pull out correlations and propose arbitrage trades based on them.
Risk Profile of Relative Value Funds
Relative value funds tend to be lower risk and perform better in low volatility markets. If markets become volatile, it becomes more difficult to take advantage of relative changes in price, as investors become more willing to dump certain securities for safer havens. Relative value funds can use strategies to hedge against overall market volatility, but the historical trends and correlations they are utilizing hold up best in calm markets where participants are acting more or less as they always do.