Wednesday, May 28, 2008

Relative Value Hedge Funds

So...how much is your cousin Dave from across town worth to you? No, not that kind of relative value. Here, we're interested in the relative performance between two securities.

Hedge funds can be broadly classified into three categories:

1) Relative Value
2) Event-Driven
3) Directional

In relative value hedge funds, we don't actually care whether the market goes up or down, because its not going to affect us. Why? Because we're long one security, and short another.

Let's illustrate with an example. Let's say you think WestJet will outperform Air Canada. You buy shares in WestJet and you short shares in Air Canada. The only way you make (or lose) any money is on the relative performance between the two securities. If the airline industry is hit with a September 12th (some sort of sequel to Sept 11th), it doesn't affect you at all, because your short position in Air Canada will cover the losses in your long position in WestJet.

The advantage of this strategy is its ability to perform well in both bull and bear markets. And this strategy is not limited to stocks; it's just what I used in the illustration above. You can use this strategy on sectors, countries, indexes, and even convertible securities (buy a company's convertible debt, short its stock...you get the interest payments for the debt you hold, but aren't subject to the fluctuations in the stock price!).

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