Bond Hedging

The market-neutral equity manager buys attractive stocks and sells short unattractive stocks, trying to take away the effect of broad market moves. The bond hedger buys attractive bonds and sells short unattractive bonds, also trying to remove the effect of broad market moves. The attractive bonds usually have a higher yield than the unattractive bonds, so there is a yield spread between the long portfolio and the short portfolio. If a high-quality corporate bond offers a yield of 6.0 percent...

Momentum And Risk Management

Real investors often make fun of momentum investing, dismissing it as mindless trend following that ultimately destabilizes markets by setting up a dangerous positive feedback loop. The feedback loop accentuates whatever trend is already in place until it becomes unsustainable, at which point the trend collapses dramatically. What markets need is real investors who know a bargain when they see one. They buy when prices are going down, and sell as prices move up. This adds stability to markets...

Short Selling

Short selling is the mirror image of buying on margin. When you buy on margin, you buy stock that you can't afford. So you make some sort of down payment, then borrow the cash that you need to make the purchase. When you sell short, you sell a stock that you don't own. So you borrow the stock, pledging cash or some other asset as collateral for the loan. Then you sell the stock, in the hope that you will be able to buy the stock back in the open market at a lower price, at which point you can...

Longshort Equity

The simplest example of a relative-value strategy is what is often called pairs trading. For example, you think Cisco Systems is a fabulous company and that it is substantially underappreciated in the market. But you acknowledge that Cisco faces many risks, some related to markets and the economy in general, some more specifically related to the technology sector. So you are reluctant to take an outright long position in Cisco. However, you are very confident that Cisco is better positioned...

Hedging Versus Speculation

Sometimes hedge funds take short positions simply to make money. They buy stocks that they think are going to go up and short stocks that they think are going to go down. This is officially classified as speculation, since the object of the short selling is to increase return. But sometimes hedge funds take short positions in order to hedge. The object here is not to increase return but to reduce the risk that is already present in the portfolio. To understand how hedging works, it's helpful to...

Distressed Debt

The distressed debt investor is mainly interested in two kinds of bonds those that have extremely high yields and those that have no yield at all. The bonds with a very high yield might be called stressed bonds. The bonds with no yield are defaulted bonds. The category of distressed debt includes both the stressed and the defaulted. The stressed bonds are still paying interest, but the underlying companies are struggling under excessive levels of debt. These bonds will be trading at a...