Event-Driven Hedge Funds
Managers of Event-Driven Hedge Funds seek to exploit inefficiencies in the market around the time of certain events. These events include a broad spectrum of situations such as upcoming mergers and acquisitions, bankruptcies, leadership transitions, share buybacks or industry-specific transformations. As with most other investment strategies, the key is to accurately determine the intrinsic value of a security compared to the implied value. Then, in order to exploit an event-driven opportunity, a hedge fund manager often combines long and short positions. Securities subject to event-driven trading range from equity, preferred shares, to bonds, and will depend on the specific event and the specialization of the hedge fund.
Important events are usually classified into three categories.
− Distressed securities
− Merger and acquisitions (M&A)
− Earnings/Dividends surprise
− Other special situations
How the business cycle impact event-driven strategies
The number of opportunities under each category varies with the business cycle. When an economy is booming, business activity is high, with more M&A deals. On the contrary, when an economy is depressed, companies generally see a decrease in demand together with tightened credit markets, which in turn leads to financial difficulties even for the best companies, with the number of distressed securities in the market increasing.
Short-lived vs. long-lived mispricing
Mispricing of a stock can be either short-lived or long-lived.
It’s important to notice that financial markets often are highly efficient. Hence, if there is a clear reference on which the market price is based, such as the earnings expectations for a specific company, then this reference will quickly adjust to any new information which alters the expectations, as will the price of the security. And if the impact of an event can be quickly quantified using quantitative techniques, any mispricing stemming from the event is likely to be short-lived. In other words, the more apparent the mispricing of a stock is, the more short-lived it tends to be. Short-lived mispricing is often seen in relation to earnings- and dividends surprises above or below expectations. When it comes to short-lived mispricing, the speed of the analysis together with order execution speed and trading automation may play a central role.
Sometimes the mispricing of securities is harder to interpret and requires a more qualitative approach. This, in turn, opens up for more long-lived mispricing of securities, which may be seen in relation to M&As, leadership transitions, bankruptcies, and distressed companies. We’ll discuss these strategies in more detail in a separate article. But what we can say already, is that when the mispricing of securities is long-lived, it’s vital for the hedge fund manager to combine intrinsic value analysis with a thorough evaluation of investment timing. If the timing isn’t there, it’s easy to get squeezed out of a position although it will prove to be correct in the long-run.
One benefit of long-lived mispricing is that it gives the hedge fund manager enough time to acquire a large position. However, also short-lived mispricing may be successfully exploited.
High entry barriers to the best hedge funds
As you may understand, the success of an event-driven hedge fund is highly dependent on the skills, and experience of the hedge fund manager and the best hedge funds attract a lot of capital, leading them to raise the minimum investment requirement, not rarely at and above $1.000,000. What we do at HedgeMix, is that we execute bulk orders for our Fund of Hedge Funds. This way, we make sure to comply with any minimum investment requirement that the hedge fund manager may apply so that we can invest in the very best funds. We look for hedge funds with a strong track record for a period of 2+ years. In terms of quantitative performance, we especially look at the Sharpe Ratio, the number of negative months and the max drawdown of a hedge fund.