Hedge Fund Approaches

The One Strategy That Overflows With Returns From Now Until Evermore.

Rather than focusing on the hedge fund equivalent of the fountain of youth, recognize the reality that every strategy will lose its edge eventually. The only way to win over time is to understand the most consistently profitable themes and to always be searching for new ways to capture expressions of those themes.

Here are some examples of themes that have consistently been winners:

Regulatory Arbitrage.

The government is not motivated by profit, which makes them extremely easy to profit off of. Examples:

1. When the government was trying to unwind the ‘bank bailout’ Troubled Asset Relief Program (TARP), hedge funds and private equity funds were essentially picking up free money off the ground. (See WSJ: Hedge Funds, Private Equity Win Big at TARP Auctions.) What happened was that the government already “made a profit” on the program, which is politically all they really needed to declare the program a success. At that point, keeping the program alive longer to maximize profitability was more of a political liability than it was worth, so they unwound it (to the benefit of smart hedge funds.)
2. The electricity regulators have a reputation for being so incompetent that their complex rules and regulations provide electricity traders with innumerable opportunities. As Bloomberg put it, “FERC (the electricity regulator) builds markets with so many bells and whistles and buttons and valves that some of the buttons end up having no function but to dispense money. If you can find those buttons, what you do is just keep pressing them until the FERC notices and gets mad at you..”

Messy, Inefficient Markets.

The best way to extract an edge is to find the least efficient markets out there and establish a more efficient approach. Markets change over time, so it is important to respond dynamically as markets improve.

1. When Benjamin Graham wrote “Intelligent Investor” back in the 1940’s, equity & fixed income analysis was not nearly as systematic as it has become. The information wasn’t all contained in a nice little Bloomberg terminal; you had to call the exchange or brokers for pricing, you had to track down the company audits and financials, and you needed to source the information yourself.
2. When Michael Milken came onto the scene in the 1980s, the ‘junk bond’ market practically didn’t exist. He essentially reinvented the market and opened up a totally new corner of finance that remains powerful today (and was craftily re-named the ‘high yield’ bond market)
3. The edge in ‘traditional’ equities and fixed income is largely gone but there are always new frontiers, whether they be geographical (Africa, Asia, South America, Middle East) or in new types of securities such as structured products & securitizations.

Rational Actors With Systemic Constraints.

This is similar to regulatory arbitrage because in each case we’re dealing with actors who have differing motivations & constraints. Here are several of the many examples of this theme:

1. When a stock is being added to an index, the ETFs representing that index often MUST buy that stock as well. By understanding the rules of index additions/subtractions, hedge funds can trade ahead of the forced buying and capitalize on those rules.
2. In bankruptcies, many holders of equity or debt must maintain a high level of liquidity to meet their investment objectives (like mutual funds, for example). Distressed debt hedge fund investors have a longer time horizon and can invest in illiquid assets, so they are able to extract gains by purchasing assets at a discount from those who need the liquidity.
3. Tax-aware investors often harvest their tax-losses at year end. In other words, if half of a typical portfolio are losing positions, investors may sell the losers in November or December to “lock-in” the losses for tax purposes. Those same stocks often get re-bought in January. This is a completely rational behavior, but there are several hedge funds who will target those securities and trade against the investors, capitalizing on their constraint.

Informational advantages.

The ‘easiest’ way to win is to simply have better information. Some variations of this theme are illegal (like insider trading), but there are numerous ways to legally access more or better information. Several examples:

1. Some funds focus on trading in unsophisticated markets, whether it be in microcap stocks where they are trading against “retail” investors, or whether it be in new geographies overseas where investors may not be as experienced.
2. Distressed funds know the bankruptcy process better than typical investors. They understand when & how to push for their rights, they understand how to navigate the paperwork process, and they understand how to assess the value & risks of an asset in bankruptcy better than normal investors. They capitalize on this informational advantage to pay less for assets than they are actually worth.
3. Other funds focus on finding unique data sources to extract an edge. A very interesting WSJ article shared that some funds use satellite imagery to determine whether crops are growing at the expected rate. Others use satellite imagery to gauge whether parking lots are full or empty at specific retailers. Others measure the shadows cast from buildings to estimate the rate of new construction in major cities. Some funds capitalize on the fact that different regulators require companies to report revenue or earnings on earlier schedules than others. The list goes on but there are an innumerable number of clever ways to find more information and capitalize on it.

In Conclusion.

Find a winning theme, then search for the most effective way to express it. This is the core of what drives the most profitable strategies and what drives the field of finance forward.

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FX Carry Trade

This is also often referred to as “global macro” although this is a misnomer — global macro is a collection of strategies including various other investments involving economics of foreign economic policy.

This trade is simple and has performed well historically. What you do is purchase a currency with a high interest rate and finance the trade by selling a currency with a low interest rate.

For example, New Zealand Dollars (NZD) have historically had interest rates approximately 2.5–3% above US. Additionally, due to high dependence on the US economy these rates are highly correlated and this relationship doesn’t deviate too much. As of September 2015 NZD Reserve Bank rates are 3.0% compared to 0.25% in the US.

However, in order to arbitrage these interest rates, you would be subject to FX exchange risk. (NZD/USD)

Over the past 10 years, you would have made approximately 29% on capital by shorting US treasuries and investing in NZD government bonds. However, this gain would be balanced by the difference in FX rates (NZD/USD has weakened approximately 11% during the period of 2006–2015). The net gain would therefore be approximately 18% (1.8% per year).

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• Arbitrage — buy cheap things and short nearly identical expensive things. There are many subtypes: merger arb, convert arb, capital structure arb, index arb, and so forth.
• Value — same basic idea as arbitrage but using things that have less correlation (like buying the cheapest stock in each industry and shorting the most expensive). The lower correlations mean each position has more risk, so you have hundreds or thousands of positions.
• Carry — buy things that pay high cash return and sell similar things that pay low or zero returns.
• Momentum — buy things that are going up and short similar things that are going down.
• Price pressure — buy things that other investors have to sell for non-economic reasons, short things that other investors have to buy.
• Quant models — use sophisticated mathematics to predict future distributions of prices.

While all of these are simple in principle, execution can require both intensive research to design and calibrate properly and financial skill to execute. On the other hand, plenty of individuals take advantage of these same strategies without a lot of research or professional execution skills; and make nice livings trading an hour or so a day in their bathrobes.

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They want to know what companies have the best potential to have blow out earnings. Earnings or EPS, earnings per share multiplied by the Price-Earnings give you an expected stock price. If you can figure out a trajectory that EPS should be much higher than the Street and that the PE multiplied by the EPS can reasonably give you a much higher stock price you have a reason to buy. Most hedge funds, at least the ones I know typically if asked have an EPS number for each stock. That tells you what they think about the stock. Anybody can do it really. We simply figure out the trajectory of where the earnings can go in our earnings models.

Earnings, in my experience, are mainly what drives individual stocks. You can’t say a stock’s cheap or expensive until you’ve worked through the model to come up with your own EPS number.

Everybody can do it but most don’t but it’s a very valuable exercise to see if something’s worth owning.