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Understanding Alternative Equity Strategies

| December 15, 2016

Oftentimes, when seeking equity exposure with lower risk, investors come across alternative equity investments. These are liquid alternative funds that are often classified as 'market neutral', 'long/short', or 'hedged equity'. Unfortunately, these labels don't explain very much about the actual underlying strategies or the risks inherent within the funds. This is especially problematic because there is a wide variety of strategies within this space and the risk profiles of these approaches can differ drastically. The purpose of this post is to delineate the main alternative equity strategies and their different risks.

Stable Beta Long/Short: These funds use either fundamental or quantitative approaches to selecting both a long and short book of equities. Their goal is to maintain a stable amount of market risk (a stable “beta”) so investors have a consistent level of exposure. The managers seek to outperform the expected return on this market beta by stock selection in both the long and short segments of the portfolio.

Tactical Long/Short: This strategy often employs the same long/short approach as described above. The difference is that, rather than having a stable beta, these investments have a dynamic degree of market exposure. The managers try to add to returns by tilting the extent of equity market risk based on timing signals. Some funds will operate within a range that constrains the fund’s beta, but others will be completely unconstrained. Understanding these limits (or lack thereof) is necessary to recognize the extent of the additional uncertainties associated with a tactical strategy. 

Traditional Market Neutral: A traditional market neutral fund is akin to a stable beta long/short in which the market beta is set to zero. The idea is that all the returns stem from the difference in performance between the long and short parts of the portfolio. Unlike with long/short funds, there is no market risk. This can be a negative for investors that want some degree of equity exposure, but can be attractive for investors looking for returns that are less correlated to the equity markets. 

Equity Risk Premia: On the surface, these funds may look similar to a traditional market neutral investment. However, rather than using fundamental or quantitative screens to select stocks, equity risk premia strategies use equity factor analysis to make trading decisions. The managers make investment choices with equity factors (like value and momentum) in mind - the stocks themselves are simply the vehicle by which the factors are accessible. This company agnostic approach leads to extremely low holding periods and very high turnover. Additionally, because these strategies view themselves as “harvesting” persistent return sources, some will utilize leverage to enhance performance. This use of leverage can expose investors to additional risks. 

Covered Call Selling: The simplest of hedged equity strategies, covered call selling involves buying stocks and selling call options on those stocks in order to gain the additional income from the option premium received. This strategy offers higher income along with lower volatility than unhedged equity funds. The drawbacks of the strategy are twofold: (1) the sale of the call options limits the fund’s upside in a strong bull market, and (2) the premium from the option sales provides limited income that will only slightly mitigate losses in the event of a large down move in the equity markets. 

Advanced Hedged Equity: These strategies try to provide the benefits of a covered call selling strategy (enhanced income and lower volatility) while using other stock options to limit downside exposure. One approach is to use a “collar” (which involves selling call options and buying put options) to limit the fund's potential losses in the event of a market collapse. Other funds will use even more advanced option structures in order to capture income from option sales while mitigating risk. 

Event Driven Arbitrage: Often grouped in with market neutral strategies, arbitrage funds seek to profit from pricing inefficiencies that exist in stocks that are involved in a mergers or other corporate restructurings. When mergers or other corporate transactions are announced, the pricing of the related securities will not move all the way to parity with the deal terms because of the possibility that the merger or restructuring will not occur. Arbitrageurs scrutinize the deal terms, consider the likelihood that the deal ultimately succeeds, and invest accordingly. Oftentimes, these funds can further reduce risk by placing hedging trades to mitigate losses in the event that the transaction never occurs. 

Before investigating any alternative equity strategy, an investor should begin by determining the role that the investment is to play within their portfolio. This will help point the investor towards the specific strategies that are appropriate for that portfolio segment. Research will be necessary to fully grasp the intricacies of the specific fund possibilities. While this is more time consuming than evaluating more typical long-only equity investments, alternative equity strategies offer the possibility of improved risk/return profiles and differentiated sources of return. These potential benefits make them a compelling choice for inclusion in many investor portfolios. 

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