Relative Value Arbitrage: Hedge Fund Basics

Relative value arbitrage aims to capitalize on pricing discrepancies between historically correlated securities. 

By simultaneously going long undervalued and short overvalued assets, funds isolate valuation distortions while hedging general market moves.

This guide unpacks the allure of this predominantly quantitative strategy, exploring:

• The evolution of relative value arbitrage
• Common strategy variations
• What drives fleeting opportunities
• The skills and expertise required
• Real-world examples
• Performance essentials

By the end, the method behind relative value madness will make sense.

Let’s dive in.

Relative value arbitrage identifies assets with a persistent price relationship trading out of equilibrium. Funds structure paired long/short trades expecting spreads to mean revert.

History

Relative value arbitrage emerged in the 1980s, led by quantitative pioneers like Ed Thorp applying mathematical finance theories to capital markets. What began as a niche strategy now attracts significant hedge fund assets.

Portfolio Benefits

Since relative trades are market-neutral with minimal correlation to broader assets, integrating them improves portfolio diversification and risk-adjusted returns.

Workings

In practice, managers run statistical analyses to pinpoint price deviations between historically pegged instruments like related stocks, bonds, commodities, etc.

Proprietary algorithms or human judgment determine when spreads widen enough to justify entering offsetting long-short positions, expecting valuations to converge over time.

While endless niche iterations exist, most relative value funds employ these core hedge fund strategies:

Equity Market Neutral

This classic approach identifies overvalued and undervalued stocks to simultaneously buy underpriced names and short overpriced names. Funds hedge systemic risks to isolate stock-picking alpha.

Fixed Income Arbitrage

A mainstay strategy, fixed income arbitrage targets relative mispricings between related interest-rate securities, like treasuries, swaps, futures, and options with varying maturities.

Convertible Bond Arbitrage

A common approach is targeting pricing aberrations between a company’s convertible bonds and stock. Funds buy undervalued convertibles and short overvalued equities as a package.

Volatility Arbitrage

Increasingly popular, these strategies look to capitalize on distortions in implied vs. realized volatility across derivatives like options and variance swaps.

Shrewd managers identify three primary catalysts creating periodic mispricings:

Investor Biases

Cognitive pitfalls like anchoring, confirmation, and neglect bias lead to valuation disconnects, such as similar stocks trading very differently.

Market Plumbing

Technical factors like derivative hedging flows and index rebalancing often distort pricing between aligned assets like index ETFs and futures.

Complex Securities

Assets with multiple interrelated equity/debt components, including convertible bonds, preferred shares, and closed-end funds, often misprice.

Rule Differences

When similar assets trade on multiple exchanges with contrasting rules, tracking mismatches emerge.

Perpetual opportunities emerge since asset prices virtually never precisely reflect intrinsic values at all times. Relative value traders aim to systematically seize upon these frequent, small distortions.

The Expertise Required

Successfully executing relative value strategies rests on specialized skill sets:

Financial Engineering

Architecting intricate asset pair trades requires mathematical creativity and problem-solving to maintain balanced exposures.

Programming

Algorithmic coding chops enable the building of statistical arbitrage strategies and dynamic position management systems.

Data Analysis

Crunching pricing data reveals subtle relative value opportunities. Scientific rigor combats overfitting bias.

Risk Modeling

Robust correlation and volatility assumptions keep multi-asset trades properly hedged and portfolio risk contained.

Managers also stress creativity to discover fresh relative value 

variants before the competition arrives. First-mover advantage secures better spreads.

While alluring in theory, poor risk controls can crater funds, as highlighted in these cases:

LTCM Meltdown – The epic 1998 collapse of fixed income arbitrage pioneer Long Term Capital Management serves as a precautionary tale for the field. Gusty leverage assumptions without macro hedging proved fatal.

VIX Blowup – During the February 2018 VIX spike, several volatility targeting mutual funds trading volatility futures saw huge losses. Flawed risk modeling assumptions sank strategies.

Mortgage Arbitrage – Many fixed-income arbitrage funds bet on stability in the yield spread between mortgage securities and treasuries up to 2008. The financial crisis exposed this false sense of safety.

Spectacular failures are frequently traced back to underestimated fat tail risks. Bulletproof risk management separates the best from the rest.

Veterans stress three vital pillars for realizing relative value arbitrage’s theoretical promises:

Disciplined Execution – Meticulously structuring and dynamically adjusting trades while minimizing costs paid to intermediaries.

Diversification – Blending varied strategies and continuously targeting new opportunities avoids herd risk.

Robust Risk Management – Rigorously backtesting models and maintaining strict volume limits by strategy insulates blowup threats when spread trades inevitably go against you.

Getting the process right ultimately determines if managers thrive or dive.

For investors considering launching relative value arbitrage funds, veterans emphasize key steps:

Refine your expertise – Cultivate mathematical finance and programming skills through advanced coursework and practical experience. Read seminal papers.

Obsess over risk control – Rigorously stress test models for faulty assumptions. Adopt institutional-grade position limits, concentration guidelines, and loss triggers.

Build a differentiated niche – Explore creative avenues like machine learning for undiscovered “alpha.” Avoid overcrowded strategies.

Plan for scale – Design institutional-grade trading architecture, optimized algorithms, and hardware to manage large capital bases. Seek anchor investments.

Temper expectations – Appreciate statistical uncertainties inevitable in arbitrage trading. Pursue new strategies when competitive pressures squeeze incumbent ones.

For patient talent willing to hone expertise, relative value arbitrage still offers a path to generate differentiated returns at attractive risk-adjusted levels – if executed deliberately.

The barriers to entry are high, but so is the allure of quietly earning steady profits by exploiting market oddities bound to close over time.

While intensive computationally, relative value arbitrage strategies offer diversity for portfolios. Veteran quantitative traders develop almost a “spidey sense” for spotting obscure market dislocations among vast arrays of assets.

The rules-based philosophy contrasts with discretionary hedge funds, but memorable wins have 

demonstrated viability. After this overview, the method behind relative value arbitrage funds madness should seem less bewildering. 

Relative Value Arbitrage FAQ

What is the difference between relative value and arbitrage?

Relative value targets assets with a historical price relationship trading out of equilibrium, while arbitrage exploits sure-fire pricing discrepancies. 

What is an example of a relative value strategy?

An example is equity market neutral funds that buy undervalued stocks and short overvalued stocks in a sector.

What is relative value fixed income arbitrage?

It targets relative mispricings between related interest-rate securities like treasuries, swaps, futures, and options. 

What is relative value in multi-strategy?

In a multi-strategy context, it contributes market-neutral trades to diversify risks and enhance risk-adjusted returns.