There are five different types of strategies under the convergence trading category, that take long and short positions in two similar but mis-priced securities in order to earn the arbitrage spread. Hedge fund managers that utilize convergence trading strategies are akin to insurance sellers, or underwriting an insurance policy. Should an outlier event occur (e.g., a hurricane), then the insurance buyers will be compensated. There are five primary sub-types of convergence arbitrage strategies, namely fixed income yield alternative, fixed income arbitrage, relative value arbitrage, convertible bond arbitrage, and equity market neutral.
In this article, I will focus on equity market neutral. Equity market neutral is the only arbitrage sub-strategy that minimizes market and credit exposure with zero beta. This means all gains in the hedge fund portfolio attributed to this strategy are from security selection. The third and fourth moments are namely very low positive skewness and kurtosis respectively, which means the return distribution is close to normal. Low values for kurtosis indicate the insurance risk/outlier event risk is very low, and with a Sharpe ratio which is greater than the broad stock market indicates that it is ideal for risk-averse investors.
When juxtaposed to a long-short strategy (under the market directional category), the market neutral strategy applies the rule of one alpha, which seeks to eliminate portfolio beta risk (which explains the zero beta) by construction of long and short positions. The goal is to produce a single return based on stock selection only, which emphasizes the importance of a hedge fund manager’s skill.
In contrast, the equity long-short strategy has two distinct portfolios, a long and a short, which means the hedge fund manager is able to capitalize on his expertise (e.g., in a healthcare sector) to go long and go short, thus extracting two different alphas in the process. Thus the net beta exposure is positive, not zero like in the equity market neutral strategy.
The following article talks briefly about equity market neutral, a strategy adopted by Swiss hedge fund manager Gottex, which is currently in positive territory: UPDATE 1-Gottex swings to profit as flagship fund performs
About the author:Graduated with BA Economics from National University of Singapore. Passed Level 1 of the CFA examination and CAIA Level I Candidate. Long-biased US equities, with strong focus on small to mid-cap stocks (NYSE, NASDAQ, AMEX, OTC & ADR) utilizing fundamental and technical analysis.
Agnostic investor, trader, writer and perpetual student of the market.