Hedge Fund

lar pairs, a hedge fund can choose from a practically unlimited number of
pairs. With each step away from pure arbitrage, the hedge fund assumes
greater risks. The fund manager may face a market environment in which
the statistical relationships break down.
The success of a pairs strategy depends on being able to identify which
stocks to buy and which to sell. The pairing of longs and shorts signifi-
cantly reduces the risk from general movements of stocks and the perfor-
mance of particular sectors. By carrying a portfolio of pairs positions, the
hedge fund also benefits from diversification, which reduces the volatility
of hedge fund returns.
Equity Market Neutral--Index Arbitrage
Hedge funds may employ several strategies to take market neutral posi-
tions in common stocks. One popular strategy involves trading a basket of
stocks versus an index of stock returns. In its purest form, arbitrage in-
volves simultaneously buying an asset in one market and selling it in an-
other. The markets may be separate geographically (gold in London versus
gold in Tokyo) or at different times (spot versus forward).
Index arbitrage begins with buying or selling the individual stocks
that make up an index and simultaneously hedging with a derivative in-
strument that tracks the index (for example, a futures contract). Traders
might buy all 500 issues in the S&P 500 index and sell the futures con-
tract. When the futures contract is fairly priced relative to the index, the
hedge fund can sell the long positions in the individual stocks and buy
back the futures position.
A wide number of derivatives exist that track stock indexes. Index ar-
bitrage also includes trading among different equity derivatives, including
futures, options on futures, index options, exchange-traded funds, and
over-the-counter derivatives.
Spreads between certain indexes are not market neutral. For example,
a hedge fund that buys an equity derivative that tracks the Nasdaq Com-
posite index and sells an equity derivative that tracks the S&P 500 will
likely make money most of the time that markets rise and lose money most
of the time that markets decline, unless the hedge fund takes steps to re-
move the market sensitivity from the position.
Equity Market Neutral--Dividend Capture
Dividend capture is usually not conducted with market neutral positions
but, because of the short holding period, the performance of the strategy
does not closely track stock market indexes.
Hedge Fund Investment Techniques
65
ccc_mccrary_ch04_59-72.qxd 10/6/04 1:42 PM Page 65