The pandemic has had a profound impact on the investment management industry. Hedge fund managers faced unique challenges during this volatile period, and many tactics that worked in the past had to be adjusted to fit the changed landscape of the world of investments.
The hedge funds took this time to reassert their tactics and strategies, introducing new parameters and hedging options to amortise against black swan events, considering hedge funds are typically entrusted with long term portfolio management. Regardless, according to HFM Insights, 76% of investors said that hedge funds were delivering value for money in 2020.
The following are some of the hedge fund strategies that were impacted and were under larger scrutiny due to the pandemic.
Merger and Acquisition
Merger and Acquisition (M&A) is a popular (and cost-effective) technique for hedge funds—merger arbitrage funds anticipate and make profit from announced mergers.
The operation consists of buying shares of the company that is a target of a merger and shorting shares of the buying company. This is proportion to the ratio of the merger agreement.
The profits come from the target company trading at below the rate prescribed by the merger agreement. This difference between the actual stock price and the merger price is called the spread.
Despite being performed by “merger arbitrage funds”, this is not a riskless strategy. Notably, the hedge fund incurs a risk of losses if the deal does not pass through. That is why the spread needs to be large enough to compensate for the risk.
There are several conditions that need to be met in order for a hedge fund to profit from this operation. First, the spread needs to be wide enough to compensate for risk. The deal also needs to pass regulatory approval, and be approved by the shareholders of the two companies.
Any event that negatively affects the share price of the target company, or positively affects the shorted shares of the buying company will negatively impact the hedge fund’s position.
Merger arbitrage is naturally attractive during the pandemic. Mergers tend to happen more often during tough economic times. This is because mergers are typically a result of stronger companies taking over their weaker competitors.
However, in 2020 mergers and acquisitions in the United States fell by more than 50%, and many mergers were put on hold because of the pandemic.
Quant
A quant fund makes investment decisions based on advanced mathematical models and using quantitative analysis of prior events, dependencies or trends to render an impartial model for long term yield.
Quant funds perform fundamental analysis to anticipate the long-term value of a stock for the long play. One of the benefits of being a long-term investor is the ability to save and invest for big goals that require significant time to achieve the highest rewards.
They are a unique strategy as they can be fully automated, requiring no human input past their design. These automated quant funds are continuously gaining in popularity as quant trading reduces risks associated with the human error element of fund management.
Quant funds excel at day-trading and high-frequency trading. The most advanced quant funds perform best during crises, as high volatility creates many earning opportunities for high-frequency traders.
Worth to note that the continuing development of AI-trading technology is pushing the transformation for algorithmic trading methods and their implementation by hedge funds. While quant funds showed calmer numbers during the pandemic, the development paved the path for further innovations in the field.
Long/Short Equity
The Long/short equity strategy is one of the most popular hedge fund strategies. It is also the oldest—the strategy was first used by Alfred W. Jones in 1949, who is widely considered to be the father of hedge funds.
The strategy consists of taking long positions in stocks that are expected to go up, and short positions in stocks expected to go down. The strategy makes economic use of the analyst’s time, as they are likely to find both winners and losers in their research, it is worthwhile to bet on both.
Long/short equity management can use both quantitative and fundamental analysis. For the time being, fundamental investment remains more popular.
Long/short equity strategy has the crucial benefit of being market-neutral. Equity funds depend on the stock market to go up. Long/short equity hedge funds can go up even if the market goes down. If the market experiences a downturn, the gains on short positions can offset losses on long positions.
This strategy has been seen as the one of the most suitable for any market period. This benefits investors that have a moderate time horizon for investing. If they need to liquidate their positions during a correction, they will be ahead of investors that invested in equity.
That’s why long/short strategy saw an upturn in popularity during the pandemic. As investors constantly weighed the prospects of recovery with the worsening of the pandemic, many saw long/short equity as the logical solution for their predicament.
The Long/Short strategy has also been targeted by retail investors— the Reddit retail investors’ community took on Long/Short equity strategy by making GameStop’s, an American video game, consumer electronics, and gaming merchandise retailer, stocks soar.
In the long run, however, stocks are likely to outperform long/short funds, as a bet between Warren Buffett and Ted Seides had shown.
Wrap Up
Overall, hedge funds have performed well during the pandemic. The chronic uncertainty over market conditions played right into their strengths with the classic long/short strategy performing the best.
On the other hand, M&A did not perform as well as expected and short strategies were targeted by retail investors, which led to some reputational issues in the long term. Quants that looked at short term tactics had challenges they had to adjust to quickly, while those that looked at long term gains might’ve been in good standing. However, some analysts are expecting a pickup of mergers and acquisitions as the pandemic ends. This would mean that the merger arbitrage funds could outperform in the future.
Quantitative funds had a trial run of the unique economic landscape that formed due to the pandemic. While the performance was calmer than expected, ongoing transformations in AI-based trading will bring exciting opportunities in post-pandemic.
