Hedge Fund Strategies
One of the popular equity strategies employed by hedge funds is called pairs trading.
Explain how this strategy works and state key assumptions on which it is based.
First find two stocks that are historically highly correlated. When the values of the stocks diverge, should short the higher one and buy the lower one, and wait for the temporary difference in prices to disappear over time. The positions will unwind once the values converge. The major assumption is that while stocks with high correlation could diverge in value due to short-term shocks, they will always converge in the end.
What measure would you use to select securities for pairs trading? Show how you would compute this measure.
Gather data on daily returns of stocks in a certain industry. Run regression analysis and identify two stocks that are historically highly correlated.
Now that the stocks have been selected, describe in detail how you would execute the trading strategy.
Identify sudden changes in one of the two stocks caused by temporary demand/supply shocks. Short the stock that has a higher value and long the one that has a lower value.
What risks do you see in implementing this strategy? What steps can you take to mitigate these risks?
Picking the right stocks is the most important step in the strategy. If somehow the two stocks aren’t really tightly correlated then the values may never converge. So people need to do thorough background research on the two stocks followed by extensive historical financial analysis.
One other risk is that when the price of one stock changes, people need to make sure that the change is only temporary, and will not cause a permanent change in company operation/culture etc. If the change weakens the correlation between the two stocks permanently, the strategy will fall apart.
What does empirical evidence suggest about survivorship rates of new hedge funds over the short and medium term? Be specific.
New funds typically suffer from low survival rate for the first few years of its operation. Once they pass the initial stage survival rate goes up considerably.
Describe the main challenges faced by new hedge funds that may have contributed to this low survival rate.
New funds are likely to be dropped by their investors due to poor results or low asset accumulation over the first couple of years of their lives. With no or less successful historical track record, investors are more likely to pull the plug and leave when things don’t start out perfectly.
Is there anything in the structure of hedge fund compensation that may have increased