Convergence and Transparency: Keys to Successful Market-Neutral Performance - analysis of market-neutral hedge funds

Healthcare Financial Management, August, 2001 by Michael Dubes

Since the early 1990s, market-neutral hedge funds have been widely embraced by the investment community for their steady, if unspectacular, performance. Institutional investors typically view these funds as a higher-yielding alternative to traditional fixed-income vehicles. Often, however, funds purporting to produce so-called "market-neutral" returns appear to be highly correlated to the underlying markets. How can funds specifically created to hedge against market fluctuations miss their intended objective?

Part of the answer lies in understanding the term "market neutral." True market-neutral hedge funds first appeared in the 1950s. A hedge fund can be any type of private investment partnership with a wide investment mandate, from global macro to esoteric derivatives strategies to long equities. [a] Because hedge funds are not subject to the same Securities and Exchange Commission regulations governing mutual funds, hedgefund managers can use strategies that are unavailable to mutual funds to employ far greater leverage within their portfolios. Many financial executives and institutional investors regard hedge funds as riskier than mutual funds, but that is not always the case. The ideal characteristics of a true market-neutral fund include risk comparable to that of a conservative fixed-income strategy and return comparable to a conservative equity strategy Most so-called market-neutral funds fall short of their objective because the securities in their portfolio lack a discernable correlation with underlying securities, otherwise known as convergence.

Critical Convergence

Dimitri Sogoloff, principal of New York-based Alexandra Investment Management, says most market-neutral funds lack the critical convergence needed to produce market-neutral performance. "A lot of fund managers try to buy undervalued stocks while simultaneously selling stocks they deem overvalued," says Sogoloff, adding, "It's a valid strategy if a correlation exists between the two groups. But convergence-deprived funds own stocks with no real relationship or interconnectivity. They may be companies in the same industry or ones that share some similarities, but that does not qualify as convergent or correlated; they are simply a collection of stocks the fund manager believes may go up or down."

Sogoloff explains that a truly market-neutral hedge fund contains securities with a contractual interrelationship. A convertible security (or other equity derivative) and the underlying equity is one example. Here, the two securities are related through a conversion option. Typically, the strategy is to buy long a convertible security that can be exchanged for a predetermined number of common shares at a preset price, and sell short the equivalent amount of the underlying equities. The interrelationship between the two securities provides assurance that, at some future point, the two securities will become fairly priced in relation to each other. This eventual convergence between the two securities is vital because it establishes the underpinning for market-neutral performance and separates true market-neutral funds from those that are not market-neutral.

In addition to convertible arbitrage, another true convergence strategy is risk, or merger, arbitrage, where two merging companies establish a relative price for their securities at the time the merger is finalized. The market-neutral fund manager, betting that the merger will take place and the prices will converge, simultaneously buys the cheaper security and sells short the more expensive one, then waits for the merger and the equalization of the securities.

Another example of true convergence is corporate structure arbitrage, where the fund simultaneously buys and sells different classes of a company's securities. The two stock classes represent different investor groups and may be mispriced in relation to one another. This is a different approach than, for example, being long Ford stock and short General Motors stock in hopes that, because the two stocks have had a historic correlation, they may interconnect again. This ploy does not shield investors from adverse market movements because it is not a true market-neutral strategy Instead, the fund simply has two independent speculations on companies in the same industry.

Dangerous Hedging Strategies

In the early 1990s, institutional and individual investors alike were searching for market-neutral strategies. Many erroneously turned to long/short equity funds as a solution. Today, many otherwise knowledgeable people in the financial community continue to hold the misguided notion that these funds provide a market-neutral strategy

In 1998, the Long-Term Capital Management hedge fund employed extraordinarily high leverage, in which the risk of the fund's short positions failed to offset the risk of its long positions. The predictable results caused a lot of sleepless nights for the fund's investors. [b]

Another example of a dangerous hedging strategy involves cross-hedging, or hedging two dissimilar instruments. This approach failed in the 1987 market crash when long preferred-stock positions were hedged with Treasury futures. In 1987, the value of the preferred stocks fell and the Treasury futures rose. Because the two securities are not contractually related, the prices diverged and the loss was doubled by both positions moving against each other.