About a third of all hedge funds use a “relative value” arbitrage strategy. The key ingredient being leverage, which is used to suck-up nickels from around the world like a new Dyson DC47 vac. The strategy may look good on paper, but turns ugly when real life gets in the way. As an 80-year old ban on advertising by hedge funds is set to be lifted you’d be wise to prepare for the hard charging sales pitch about to come your way. Let’s not forget what happened to the smart guys at Long Term Capital Management When Genius Failed. Daisy Maxey at The Wall Street Journal explains “What is a Hedge Fund, Anyway?”
“Relative value” arbitrage strategies account for about 27% of industry assets, according to HFR. Managers of relative-value funds will simultaneously buy markets or investments expected to appreciate, while selling related securities expected to depreciate, seeking to profit from their relative value. That allows the funds to generate returns with little correlation to markets. Such strategies can be executed with convertible bonds, preferred securities, options, warrants and other instruments.
As Hurricane Katrina bore down on the U.S. in the summer of 2005, for example, some hedge-fund managers owned short-term contracts on oil and gas, a bet that prices would rise soon. But they also took bearish positions on longer-dated contracts, a bet that the prices would fall in coming months.
Relative-value arbitrage funds may employ lots of leverage, which can result in big gains or losses. Long-Term Capital Portfolio LP, which famously collapsed in 1998, was a relative-value fund.