The event-driven category includes those funds that seek to capitalize on price fluctuations or imbalances stemming from a specific event occur- ring during the life cycle of a corporation, such as a merger, bankruptcy, corporate restructuring, or spin-off. This category can be broken down into four specific strategies: (1) distressed securities, (2) risk (merger) arbitrage, (3) special situations, and (4) sector funds. The individual strategies within event-driven investing can be employed individually or simultaneously, depending on the investment process of the individual manager. These strategies also could be classified as nondirectional instruments inasmuch as the outcome is largely dependent on company- specific issues that have little or no correlation to market movements.
Other opportunistic strategies encompass a range of niche strategy specialists who offer the ability to capitalize on shorter-term inefficien- cies. These managers frequently work in highly distressed, newly devel- oped, or otherwise inefficiently priced markets or sectors. Due to the
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reduced liquidity inherent in many such situations, these managers fre- quently run smaller pools of capital than their institutional counter- parts. Examples of opportunistic strategies are microcap stocks (often called small cap or sector funds).
Distressed Securities
Sometimes referred to as vulture investors, distressed securities managers typically invest long and short in the securities of companies undergoing bankruptcy or reorganization. Managers tend to focus on companies that are undergoing financial rather than operation distress—in other words, good companies with bad balance sheets. Overleveraged companies that are unable to cover their debt burden become oversold as institutional bondholders liquidate their holdings. As the companies enter bank- ruptcy, distressed securities managers buy the positions at pennies on the dollar. Managers often become actively involved in the workout process and frequently have in-house legal teams to fight for advanta- geous treatment of their class. Some distressed securities managers also invest in the equity securities issued at the end of the bankruptcy pro- ceedings. These securities, called stub equities, often are overlooked by traditional investment managers. Other distressed securities funds have moved into the loan origination business. These funds approach the mar- ket with a more creative attitude than traditional lenders and are willing to do the work to accurately appraise unusual types of collateral. The loans are typically shortterm, highly collateralized, and very expensive.
Lending rates typically start at 15 percent. Although commonly viewed as a risky investment, volatility actually varies with the strategies employed and the securities held. Volatility of returns is greatest among those managers investing in high-yield debt and postbankruptcy stub equities. Lower-volatility investments include late-stage investing in sen- ior secured debt. This strategy typically does not use financial leverage.
Risk Arbitrage
Risk arbitrage (also called merger arbitrage) managers take a long posi- tion in the stock of a company being acquired in a merger, leveraged
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buyout, or takeover and a simultaneous short position in the stock of the acquiring company. If the takeover fails, this strategy may result in large losses. Often risk is reduced by avoiding hostile takeovers and by investing only in deals that are announced. In recent years the spreads between the prices of the stocks of companies involved in these transac- tions have reached all-time lows. The potential profit spreads between the initial offers and the final deal prices are greatest in hostile transac- tions. Most transactions announced today are friendly, and, in the case of unsolicited offers, the initial bids often are very close to the final number. To overcome this problem, many risk arbitrage managers are increasing the risk profile of their portfolios, which is evidenced by an increased level of leverage and greater net-long exposures.
Special Situations
Event-driven managers can take advantage of special situations with a significant position in the equity of a firm. Many special-situation investments cross over into distressed securities investments and risk arbitrage. However, special-situation managers tend to focus on new or underfollowed areas of opportunity, such as emerging market debt, depressed stock, impending (i.e., unannounced) mergers/acquisitions, reorganizations, and emerging bad news that may temporarily devalue stock prices. Typically leverage is not employed. The nature of the investments made involves greater volatility than the other event-driven strategies.
Sector Funds
Sector funds represent a top-down approach to investing within the domestic hedge fund category. Sector funds invest long and short in the companies of specific sectors of the economy. Examples of such sec- tor specialization include technology companies, financial institutions, healthcare and biotech companies, electrical utility companies, real estate investment trusts (REITs), entertainment and communications com- panies, gold stocks, and energy companies. Managers construct port- folios of long and short positions based on a research-intensive process.
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Why should investors consider hedge funds? The facts speak for themselves. The differences between alternative and traditional invest- ments are manifested in historical returns, and alternative investment strategies outperformed traditional investments on a risk/return basis from 1994 to 2000. Despite the Standard & Poor’s (S&P) 500 slightly outperforming hedge funds on an average annual return basis from 1994 through 2000 due to the market’s unprecedented bull run, hedge funds still averaged more than 15 percent annual returns over the period. When the time period is expanded to include all years since 1989, hedge funds have outperformed the S&P on an average return basis as well as 50 percent better on a risk-adjusted basis. When the subsequent bear market years of 2000 to 2002 are included, hedge funds outperformed the S&P 500 on both an absolute and a risk- adjusted basis.
In addition to outright performance, hedge funds also can signifi- cantly reduce the overall risk of a portfolio because of the low correlation of these fund types with the market and among hedge fund categories. A study by Duke University researchers indicated that more than half of all mutual funds have a correlation to the market of greater than 75 per- cent; typical hedge funds have a much lower correlation with the mar- ket. The low correlations of alternative investments can make them an ideal diversification tool for any portfolio. Modern theory states that adding a noncorrelated, volatile investment to a portfolio can reduce the overall volatility. Adding alternative investments to a traditional equity and fixed-income portfolio reduces overall portfolio volatility, and the end result is a substantially greater risk-adjusted return.
For a predetermined level of risk (standard deviation), a portfolio including hedge funds has the potential to deliver a higher risk-adjusted return to the overall portfolio. (See Table 1.4.)
Investing in hedge funds requires a determination of the appropri- ate portfolio allocation and the identification of strategies in which one seeks to invest. The first step in investing in a hedge fund is the same as in making any other investment decision: determining the individual investor’s overall objectives by specifying as clearly as possible both return requirements and risk tolerance. After a full consideration of the investor’s time horizon, tax considerations, liquidity constraints, regula-
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tion, and other circumstances unique to the investor, one then can for- mulate an investment policy that will allocate funds in the most appro- priate fashion. This process includes specifying the asset classes to be included in the portfolio, determining capital market expectations, deriving the most effective alternative portfolios, and funding the opti- mal asset mix. In making specific alternative investment decisions, one should always try to have realistic expectations about how any given investment contributes to achieving one or more of only three ultimate reasons to invest in hedge funds: return enhancement, risk reduction, or specific investment opportunities that are otherwise unavailable.