Relative Value Investing: A Sophisticated Portfolio Hedging Technique

In periods of high market volatility, “relative value” is frequently cited as an attractive investing strategy by investors seeking to protect their portfolios and achieve strong returns.

Hedge funds frequently invest in relative value. By utilizing leverage, fund managers can take long positions in assets they believe to be undervalued, while simultaneously taking short positions in comparable securities they believe to be overvalued.

In this article, we will examine the definition of relative value investing, its functioning, and the risks involved.

Relative Value Investment Funds

Utilized by hedge funds, the relative value investing approach lies on the identification of price disparities. Capitalizing on such price differences by simultaneously purchasing and selling a variety of different securities can generate strong returns. Such practice is generally referred to as arbitrage.

In contrast to the majority of investment funds, which examine prospective investments individually, relative value funds examine prospective investments by comparing the values of similar assets, also known as benchmarks. A relative value fund is able to assess a company's attractiveness by comparing its pricing and fundamentals to those of other firms in its industry, whereas the majority of investors are likely to evaluate the company based on its unique characteristics. The objective of relative value funds is to identify assets that, relative to one another, are being priced incorrectly.

Whether an investment is overpriced or underpriced is a matter of conjecture; investors will attempt to determine this status by employing a vast array of distinct methodologies. Utilizing the market's tendency to revert to its mean is a common investment strategy.

Frequently, investors assume that, over the long term, prices will trend toward moving closer to their respective long-term historical averages. Therefore, if the current price of an asset is high relative to its historical level, that asset will be considered a candidate for short selling. Conversely, companies trading below their historical averages will be considered sell candidates.

Other investors could take what is known as a macro approach, in which they attempt to profit from differences in valuation across financial instruments such as stocks, bonds, options, and currency futures in relation to the performance of the nations in which they do business.

Furthermore, it is important to note that relative value fund managers frequently employ leverage to take long positions in assets they believe to be undervalued, while simultaneously taking short positions in comparable securities they believe to be overvalued.

Relative Value Investment Strategies

Funds that invest in relative value employ market-neutral techniques that capitalize on perceived mispricing between linked financial assets. For instance, arbitrage in fixed income can capitalize on short-term abnormalities in bond features, such as the yield curve. Convertible bond arbitrage, on the other hand, exploits instances in which convertible bonds are undervalued compared to the potential value of the underlying pure stock and bond.

The following are three common strategies for relative value that are utilized by hedge funds managers:

Convertible bonds

Inefficiencies between the convertible bond market and the stock market can lead to price disparities between both. A typical investment would consist of long positions in convertible bonds and short positions in the company's shares. The profit would then be realized on both the fixed income investment and the short position on the underlying stock. Combining the two positions protects the investment from market swings (frequently, leverage is utilized).

Fixed income

The objective of this approach is to capitalize on price discrepancies between connected interest rate instruments. The category encompasses the arbitrage of interest rate swap, government bonds, forward yield curve, and MBS (mortgage-backed securities).

Equities

This last technique is intended to capitalize on inefficiencies in the stock market and often involves the simultaneous purchase and sale of equal-sized share portfolios in a country. Well-designed portfolios manage industry, sector, market size, and other exposures. Leverage is frequently employed to increase returns.

Risks of the Approach

As managers of relative value have access to several markets and assets, the sorts of securities they trade will contribute in part to the types of risks incurred by the strategy.

Certain strategies, for instance, concentrate on illiquid fixed income instruments, which has a greater liquidity risk. However, regardless of the strategy's emphasis, pressured market circumstances might have an influence on all assets, necessitating the manager's attentive attention.

Managers of macro-operations are susceptible to exogenous factors like politics and natural catastrophes. These occurrences cannot be overlooked, as they may place significant strain on the market and the strategy.

In addition, it is seldom clear that two connected equities whose values have drifted, even substantially, will revert within the specified time period.

The widespread use of leverage in this sort of technique is highly hazardous for various reasons. It is conceivable, for example, to lose more money than was originally invested or to be obliged to sell shares when declining prices lower their worth.

The Bottom Line

Investors who are gearing up against increased market volatility are looking for ways to protect their portfolios by boosting their capital allocations to relative value hedge funds because of the uncorrelated and distinctive risk/return profile that these products provide.

Nonetheless, relative value investing takes a high level of competence, as the fund manager must precisely comprehend the link between assets, size trades effectively, and utilize leverage judiciously, all while making quick judgments.

Finally, it is essential to keep in mind that it is never a given that the prices of two selected stocks that are priced differently will eventually converge, which further stresses the significance of sound portfolio management and development.