A Peek Inside the Lab: Two Key Hedge Fund Strategies - Nicola Wealth

Alternative Strategies Part 4: A Peek Inside the Lab


Read Part 1 of our series on Alternative Strategies here.

Read Part 2 of our series on Alternative Strategies here.

Read Part 3 of our series on Alternative Strategies here.

We take a closer look at how two hedge funds strategies may be able to generate returns in any market.

Sunrise over the coast with a sail boat for Nicola Wealth's hedge fund strategies article.

 

So far in this series we’ve looked at what alternative strategies are and what they can add to an investment portfolio. We’ve also looked at the tools hedge fund managers use to generate returns unrelated to the macroeconomic backdrop and why these strategies are especially useful to investors in the current inflationary, late-cycle environment we find ourselves in.

In this fourth and final instalment we’re going to take a deeper dive into a couple of strategies hedge funds use to generate solid risk-adjusted returns even in a wobbly or bear market.

The first is merger arbitrage. In its archetypal form, this involves buying shares of a company subject to a takeover bid and shorting the shares of the company attempting the takeover. (Ideally this is an all-share transaction.) The objective is to capture the spread between the target’s share price upon the announcement of the deal and the price being offered and receivable at the acquisition’s close. Because there is some uncertainty, the target will typically trade slightly below the offer price. The greater the uncertainty, the greater the spread. But even if the deal is almost assured and the spread is small, the hedge fund manager can use leverage to increase the potential payoff. (Of course, if they are wrong and the deal does not go through, they could incur a loss.)

Say the hedge fund sells the acquiror short when it’s trading for $100 a share and buys the target for $98, just below the offer price of $100, and the deal is expected to close in four months. If the deal goes ahead as expected, the return is $2 or 2% over four months—equivalent to 6% a year. Now let’s consider what happens when the manager borrows $2 for every $1 up front, to acquire three shares of the target and short three of the acquiror. Now the return is 6% in four months or 18% annualized. Even when you subtract the cost of financing the leverage (3.3% in our example), the fund comes away with a nearly 15% annual return using this strategy. If the acquisition does not materialize, the stock price of the company being acquired may fall back to below where it was trading prior to takeover announcement.

The second strategy involves capturing the discounts that sometimes appear between units of closed-end funds and their net asset value. Because closed-end funds have a fixed number of units, their prices sometimes fluctuate according to the demand for the units. Demand tends to fall when investors are fearful, causing discounts to increase.

What the hedge fund manager then does is buy funds trading at wider discounts while shorting those with narrower discounts in the expectation that the gap between them will close as they eventually revert to the mean. All the while the trade is market-agnostic—it doesn’t matter which way investor sentiment moves—because the long and short positions are of roughly equal value.

These are just a couple of ways that hedge funds can generate consistent, positive returns at times like now when stock and bond returns threaten to go south. An allocation to alternative strategies can help your portfolio weather a storm and emerge better off on the other side.

 

 This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities commissions.