Chapter 21

Alternative Investment Strategies

Alternative investment strategies are broadly categorized into three types, listed in order of
increasing expected return and risk:

1. Relative Value Strategies:

• Goal: Attempt to profit by exploiting inefficiencies or differences in the pricing of related
stocks, bonds, or derivatives.
• Market Exposure: Generally, have low or no exposure to the underlying market
direction.
• Specific Strategies: Include equity market-neutral, convertible arbitrage, and fixed-income
arbitrage.

Equity Market-Neutral Strategy (Pairs Trading):

• Mechanism: Designed to exploit equity market inefficiencies by creating simultaneously
long and short matched equity portfolios of approximately the same size. The aim is to
generate returns independent of stock market direction.
• Goal: To achieve zero or very low beta (low directional exposure), with returns primarily
from manager-created alpha.
• Risk Management: Portfolios hedge risks related to industry, sector, market capitalization,
and currency.
• Leverage: Moderate leverage (typically less than two times capital) is used to enhance
returns.
• Process: Involves reviewing fundamental valuation models for mispricing, compiling
potential trading pairs, examining price-spread relationships, choosing pairs, executing trades
(e.g., shorting one stock and purchasing an equivalent dollar amount of a related stock), and
monitoring to reverse the trade at a target price spread.

Convertible Arbitrage Strategy:

• Mechanism: Identifies and exploits mispricing between convertible securities (bonds or
preferred shares) and their underlying stock.
• Execution: Typically involves buying undervalued convertible securities and hedging
underlying equity risk by short selling the issuer's common shares.
• Returns: Aims for attractive yields mostly unaffected by broader equity market movements,
with interest income from the bond and short sale proceeds contributing to steady returns.
• Behavior: Convertible bond prices behave like equities when the stock price is well above
the conversion price, and like regular bonds when the stock price is well below the
conversion price (trading on investment value based on interest rates and creditworthiness).
• Market Conditions: Can realize gains in both declining (gain on short stock exceeding bond
loss) and rising (gain from bond greater than loss on stock) markets.
Fixed-Income Arbitrage Strategy:
• Mechanism: Attempts to profit from price anomalies between related interest rate
securities and their derivatives (e.g., government/non-government bonds, mortgage-backed
securities, options, swaps).
• Leverage: High leverage (10-30 times capital) is common due to tiny price anomalies.
• Popular Strategies:
o Credit Spread Arbitrage: Managers anticipate credit risk by identifying mispriced
yield spreads between a risky bond and a similar-term sovereign government bond.
The strategy involves shorting the sovereign bond and purchasing the "cheap" credit
bond when the yield spread is "wide" (larger than it should be), profiting if the spread
subsequently narrows.
o Yield Spread Arbitrage: Managers focus on the yield curve of a single issuer,
typically a sovereign (e.g., U.S. Treasury). They forecast the shape of the yield curve,
for example, selling shorter-dated securities and buying longer-dated securities if they
expect the yield curve to flatten (difference between long and short yields decreases).

2. Event-Driven Strategies:
• Goal: Seek to profit from unique corporate structure events such as mergers, acquisitions,
stock splits, and stock buybacks.
• Market Exposure: Have medium exposure to the underlying market direction.
• Specific Strategies: Include merger (risk arbitrage), distressed securities, and high-yield
bonds.

Merger (Risk Arbitrage) Strategy:

• Mechanism: Invests simultaneously in long and short positions in the common stock of
companies involved in a proposed merger or acquisition. Typically, a long position in the
acquired company and a short position in the acquiring company.
• Profit: Aims to profit from the differential between the target company’s share price and
the offering price, which doesn't reach the full offering price due to deal risk.
• Risk Management: Returns are largely uncorrelated to the overall stock market; equity risk
is managed by focusing on probable transaction outcomes. An example describes an
acquisition scenario where an arbitrageur shorts the acquirer and goes long the target.

High-Yield Bond Strategy:

• Mechanism: Invests in below-investment-grade debt securities (junk bonds).
• Returns: Seeks returns through interest income and capital appreciation (due to credit
upgrade or takeover).
• Risk: Offers higher long-term returns but comes with a greater risk profile, including
historically higher default levels.
Distressed Securities Strategy:
• Mechanism: Invests in equity or debt securities of companies in financial difficulty, often
facing bankruptcy or reorganization.
• Profit: Managers analyze companies near insolvency and take positions in bonds hoping that
restructuring or liquidation yields a return greater than the bond cost.
• Restructuring: Can be voluntary (bondholders and management agree to new terms) or
involuntary (court-decided restructuring/payout in bankruptcy).
• Relation to High-Yield: Commonly a subset of high-yield bond strategy, but distressed debt
portfolios hold bonds currently in or near bankruptcy, potentially with suspended coupon
payments. Managers aim to profit from the market’s lack of understanding of the true value
of deeply discounted securities or institutional investors' inability to hold them due to rating
downgrades leading to forced selling.

3. Directional Strategies
• Goal: Bet on anticipated movements in the market prices of equity securities, debt
securities, foreign currencies, and commodities.
• Market Exposure: Have high exposure to trends in the underlying market.
• Specific Strategies: Include long/short equity, global macro, emerging markets, dedicated
short bias, and managed futures.

Long/Short Equity Strategy:

• Mechanism: Involves taking both long and short positions simultaneously, based on the
outlook of specific securities, with the manager having a net long or net short exposure to the
stock market.
• Goal: Managers aim to buy stocks expected to rise more in a bull market and sell short
stocks expected to rise less; in a down market, good short selections should decline more,
and long selections fall less.
• Market Risk: Exposed to market risk based on net exposure (long or short). Can profit in
declining markets by shorting and managing net exposure.
• Leverage: Usually modest, rarely more than three or four times capital.
• Net Exposure Calculation: Net exposure (%) = (Long Exposure - Short Exposure) / Capital.
• Distinction from Equity Market-Neutral: Unlike equity market-neutral, long/short equity
has net exposure to the overall market, meaning portfolio beta is not zero.
• Implementation: Can combine an equity market-neutral portfolio with a long/short position
in equity index futures, or create pair trades where long and short positions do not have equal
market values, thereby adding net market exposure without derivatives. An example
demonstrates a long/short equity strategy combining a pairs trade with a long S&P/TSX 60
futures contract.
Global Macro Strategy:
• Mechanism: Managers make bets on major events affecting entire economies, such as
shifts in government policy altering interest rates, currencies, stocks, and bonds.
• Markets: Participate in all major markets (equities, bonds, currencies, commodities).
• Leverage: Often use leverage, including derivatives, to amplify market move impact.
• Factors Monitored: Trade statistics, corporate earnings, exchange rate dislocations,
domestic/foreign policy, investor bias, non-economic activities (debt downgrades, political
events, central bank intervention).
• Analysis Styles:
o Discretionary Managers: Use a top-down analysis approach, analyzing the world
economy to predict market and asset class direction.
o Systematic Managers: Use a bottom-up analysis approach, employing models and
algorithms on large economic data sets to predict financial market price movements.

Emerging Markets Alternative Funds

• Mechanism: Invest in equity and debt securities of companies in emerging markets. It is
not a strategy itself but refers to hedge funds investing in emerging market securities.
• Difference from Mutual Funds: Greater ability to use derivatives, short selling, and
complex strategies compared to emerging markets mutual funds.
• Factors Considered: GDP growth rate, political stability, financial market regulation, social
stability, environmental stability.
• Examples: Funds may concentrate on specific regions (e.g., commodity development in
South America) or broad growth opportunities (e.g., BRIC funds: Brazil, Russia, India,
China).
• Risks: Face additional risks beyond those in developed nations, including political risk
(extreme volatility), currency risk, inflation risk, under-developed capital markets (liquidity
risk, wide bid/ask spreads, hedging risk), and transparency risk (lower-quality financial
reporting). Many strategies in emerging markets are long-only due to these limitations.

Dedicated Short Bias Strategy:

• Classification: The fund’s net position must always be short. It can hold long positions,
but the net exposure remains short.
• Distinction from Dedicated Short: A dedicated short strategy takes only naked short
positions, while short bias can have long positions.
• Advantage: Long positions help manage losses on shorts during extended bull markets.
• Disadvantage: Potential losses on long positions limit gains on shorts during bear markets.
• Skill: Identifying overpriced securities using fundamental and technical analysis.
• Major Risk: Cost of maintaining margin balances; insufficient cash for margin calls can lead
to forced closure at a loss, exacerbated by leverage.

Managed Futures Strategy:

• Mechanism: Refers to a portfolio of futures contracts actively managed by professionals.
Can be used in various hedge fund strategies, but some managers (Commodity Trading
Advisors - CTAs) specialize in futures exclusively.
• Regulation: CTAs and Commodity Pool Operators (CPOs) are regulated by the Commodity
Futures and Trading Commission and National Futures Association.
• Primary Strategy: Most follow trend-following (momentum) strategies, seeking securities
that have moved consistently in one direction.
• Trend-Following Sub-strategies:
o Time-Series Momentum: Uses fundamental and technical analysis to identify
market trend signals; assumes positive trends continue positively and negative trends
continue negatively. Managers go long positive-trend assets and short negative-trend
assets.
o Cross-Sectional Momentum: Takes positions in pairs based on relative signals; long
relatively positive momentum, short relatively negative momentum. Usually executed
on single stocks with equal long/short positions to neutralise market movements.

• Universe of Futures: Not limited to commodities; includes commodities, currencies, stock

indices, and fixed income.
• Advantages: High liquidity, low friction costs (tight bid/ask spreads), complete price
transparency, and facilitates "direct" access to underlying risk.
• Currency Subset: Currency managed futures may be classified under global macro.
Managers invest in single or multiple currencies via money market instruments combined
with derivatives. Some consider currency its own asset class, potentially increasing expected
returns for a given risk level in a traditional portfolio.

Multi-Strategy Funds
• Mechanism: A single fund manager invests in multiple fund strategies within one fund
vehicle. Exposure to different strategies may change over time based on market movements
or manager discretion.
• Benefits: Diversification, reduced volatility, potential for enhanced risk-adjusted returns, and
reduced concentration risk (security-specific and strategy-specific risks).
• Risks: Each underlying strategy has specific risks; managing more strategies can reduce time
for monitoring securities and markets.
• Distinction from Fund of Funds (FOF): A multi-strategy manager is a single manager
operating various strategies, whereas an FOF manager invests capital across a range of
 strategies managed by different managers. FOFs offer increased diversification by
investing with more managers, further reducing concentration and operational risk.
• Criticism of FOFs: Added management fees from multi-tier managers can erode returns.

Leveraged ETF Strategy:

• Mechanism: Designed to achieve returns that are multiples of the performance of the
underlying index it tracks. Uses borrowed capital (leverage) in addition to investor capital
to increase exposure.
• Goal: Generate a return from borrowed capital that exceeds its acquisition cost.
• Performance Over Time: Leveraged ETFs may multiply reference asset returns by more or
less than the stated leverage factor over periods longer than their rebalancing frequency,
depending on the path of returns. Volatility can cause returns to deviate significantly from
the stated multiple over longer periods. This is because the ETF constantly rebalances its
leveraged position, effectively "averaging up" when the asset rises, making it vulnerable to
greater losses if the asset falls after rebalancing. Investors must predict both the return and
the path of the reference asset.

Investment Strategies Most Appropriate for Alternative Mutual Funds

Alternative mutual funds must comply with regulatory limits on derivatives, leverage, short
selling, and illiquid securities, unlike hedge funds. Their requirement for daily Net Asset Value
(NAV) calculation and daily liquidity Favours certain strategies.

• Liquidity Ranking (Most to Least Liquid):

o Managed futures/commodities
o Equity market-neutral and long/short equity
o Global macro
o Dedicated short bias
o Merger or risk arbitrage
o Fixed-income arbitrage
o Convertible arbitrage
o High-yield bonds and distressed securities
o Emerging markets
o Private equity and equity real estate

• Usage by Alternative Mutual Funds:

o Most Utilised: Strategies primarily investing in futures or large capitalisation equities
(first six bullet points above).
 o Smaller Use: Convertible arbitrage, high-yield bonds, distressed securities (fixed-
income related) and emerging markets strategies.
o Very Few: Private equity or equity real estate strategies, due to inability to provide
accurate NAVs and support investor redemptions.

Alternative Strategy Fund Performance Measurement

It is important for investors to understand various risk and risk-adjusted return measures when
selecting alternative strategy funds.

• Risk Measures:
1. Absolute Risk: The total variability or volatility of returns, incorporating all sources
of risk and not distinguishing between upside and downside volatility.

2. Standard Deviation: Measures the extent to which returns differ from an average or
expected level. A larger standard deviation indicates greater risk. It can be annualized for
comparison (e.g., monthly standard deviation multiplied by the square root of 12).
However, it only gives a good indication of dispersion when returns are approximately
normally distributed.

3. Return Distribution: A graphical depiction of potential returns against their probability

of occurrence. The normal distribution is a bell-shaped curve.

4. Skew: Measures the extent to which a distribution is tilted toward negative or

positive returns.
▪ Positive Skew: Tendency for returns above what's observed in a normal
distribution.
▪ Negative Skew: Tendency for returns below what's observed in a normal
distribution.

5. Kurtosis: Measures the tendency of a return distribution to have values collecting

around the average (lower kurtosis) or toward the tails (higher kurtosis).
▪ High Kurtosis: Indicates more extreme returns (both higher and lower) than
predicted by a normal distribution, often due to "tail events" for alternative
strategy funds.
▪ Many alternative strategy funds exhibit negative skew and positive excess
kurtosis, meaning a higher likelihood of negative and more extreme returns.

6. Downside Risk: Measures of downside volatility are popular for alternative strategy
funds because standard deviation penalizes upside volatility as well, and these funds
 target absolute returns and capital preservation. This focus is crucial because alternative
fund returns are often not normally distributed and can have negative skew and positive
excess kurtosis.

7. Drawdowns:
▪ Definition: Peak-to-trough declines during a specific period, expressed as a
percentage of the peak value. A new drawdown only begins when the fund
surpasses its previous peak.
▪ Maximum Drawdown: The largest drawdown during a specific period.
▪ Time to Recovery: The number of months required to move from a
trough to a new peak (or from peak to trough to peak).
▪ These measures are useful indicators of alternative strategy fund quality given
their absolute return nature, and are verifiable and comparable. An example
illustrates calculation of drawdowns and recovery times.
o Percentage of Profitable/Losing Months: Indicates monthly success, but the
magnitude of gains/losses is more important than just the percentage of profitable
months.

8. Risk-Adjusted Returns:
o Definition: Compare returns generated to the level of risk taken. Used to compare
funds employing different strategies.
o Sharpe Ratio:
▪ Measures: Excess returns generated above the risk-free rate per unit of
risk (measured by standard deviation).
▪ Interpretation: A positive Sharpe ratio means the fund's average return was
greater than the risk-free return.
▪ Comparison: Can be used to determine out- or under-performance against a
benchmark or other funds on a risk-adjusted basis.
o Other Measures: Jensen’s alpha, Sortino ratio, Calmar ratio, and Sterling ratio.

Performance Benchmark

o Key Objective: Absolute returns for alternative strategy fund investors.

o Benchmark: A zero Rate of Return (RoR) represents the performance
benchmark for alternative strategy fund managers.
o Fee Calculation: Managers' performance fees are normally calculated based on the
positive spread between the fund's RoR and a zero return, reflecting investors'
willingness to forego higher returns for positive returns even in stressful conditions.
Due Diligence and Suitability of Alternative Strategies
A comprehensive appraisal, including due diligence, is important when considering alternative
funds.
• Key Due Diligence Areas for Advisors (AIMA Guidelines):
o Investment Manager Questions: Background, experience, governance, compliance
culture, risk management frameworks, and personal investment by senior
management/principals in the fund.
o Strategy Questions: Investment objective, principal strategies, changes in objectives,
data sourcing, decision-making process, performance history (including
out/underperformance in different markets), risk measurement methods, financial
leverage details (average, limits, sources), capacity constraints, offering documents,
fees (including performance fees), valuation policy/frequency, liquidation
timeframes, and portfolio data provision.

Comprehensive Due Diligence Process (Eight Primary Areas):

This process, originally for hedge funds, applies to alternative mutual funds too.
• Structure of the Investment Management Organization: Company origins, history,
ownership, regulatory registration/audits, information on principals/key employees
(residence, past employers, education, outside activities), senior management roles, average
experience, other business involvements of principals, loss of key personnel, personal
investment of principals/staff in the fund, compensation arrangements, pending/threatened
legal/administrative proceedings, and firm priorities.

• Investment Management Information: Assets under management (current and historical

for fund, strategy, total firm), investment committee members/tenure, number of decision-
makers, trading approaches/strategies, manager's experience, systematic vs. discretionary
approach, uniqueness of strategy ("edge"), differences from other managers, fund's
investment mandate (breadth, manager's latitude to change), current market strategy,
strengths/weaknesses, market conditions for best performance (bull, bear, congestion,
volatility), drivers of risk/return, documentation of claims, long/short bias, leverage details
(amount, calculation, historical, authorised, typical), liquidity of underlying investments, and
use of derivatives (exchange-traded vs. over-the-counter).

• Risk Analysis: How the manager identifies, quantifies, controls, and manages risk; stress
testing; beta (maximum, average, current); and transparency provided to determine risks.

• Operations: Identity and reputation of service providers (prime broker, custodian,

administrator, auditor, legal counsel); location of fund assets (offshore movements);
independent verification of NAV; and material changes to service providers.
• Fund Structure: Form of offering (prospectus, offering memorandum), tax
advantages/disadvantages, liquidity terms, conditions for suspending/cancelling redemptions,
compensation paid to advisors (initial sale, trailer fees, performance fee percentage), and
other forms of advisor compensation.

• Investment Performance: Track record start date (pro forma, audited, net of fees),
distribution of annual return (large gains vs. spread), currency exposure (hedged or
unhedged), three largest drawdowns (percentage, recovery period, reasons, manager's
response), volatility compared to peers, impact of new capital on strategy/market traded,
most appropriate benchmark, capacity constraints for strategy, fund's stop accepting new
money policy, and "perfect storm" scenario analysis (worst environment, potential decline).
Strategy drift (moving into new markets/risk exposures) is a signal of potential failure and
can mask problems, especially if increased leverage is used.

• Account Structure and Composition: Current number of clients, mix of client types
(individuals, institutions, managed accounts, FoFs), percentage of program assets by investor
type (employee/proprietary, institutional, high net worth, fund, fund of fund, offshore), and
percentage of fund owned by largest investors.

• Fees: Management fees, incentive fees, hurdle rate, high water mark, payment frequency
(monthly, quarterly, annual), and soft dollar arrangements or other implicit arrangements
with suppliers.

Suitability of Alternative Strategies:

• Complexity: Generally more complex than traditional investments.
• Risk Mitigation: Can be used to mitigate risk despite being perceived as riskier.
• Diversity: Highly diverse objectives, strategies, and portfolios mean it's inappropriate to
simply allocate to "alternatives"; sub-allocation within asset classes may be preferable.
• Obligation: Advisors have an obligation to perform suitability analysis, even for accredited
investors, ensuring they have appropriate experience, education, sophistication, objectives,
and risk profile.
• Hedge Fund Investors (General Characteristics): Excellent product knowledge, high risk
tolerance, long-term investment horizon, and little or no short-term need for liquidity.
• Liquid Alternatives (Suitability for Retail Investors): Appeals to and may be suitable for
investors with the following characteristics and priorities:
o Knowledge: Good understanding of portfolio theory, capital markets, and investment
strategies (diversification, efficient markets, alpha, absolute returns, derivatives, short
selling, leverage).
o Specific Outcomes: Focused on achieving specific objectives.
o Medium-Term Investment Horizon: Best positioned to benefit from the counter-
cyclical nature of many underlying investments; generally, not for short-term capital
gains.
o Liquidity Needs: Those prioritizing liquidity along with risk-adjusted returns and
diversification. If an investor can meet hedge fund requirements and does not need
short-to-medium-term liquidity, hedge funds might be more appropriate for
potentially higher returns.