Four Investment Strategies You’re Afraid to Admit You Don’t Understand

Demystifying equity hedge, relative value, event-driven, and macro strategies.

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Updated July 2017 — Diversity is a good thing — especially in a time of volatility. Knowledgeable investors may want to explore alternative routes to traditional equity and bond choices as one way to help manage potential risk to their portfolios.

But even the sharpest minds may have difficulty sorting through some of the terminology associated with alternative investments. Here, Adam Taback, Deputy Chief Investment Officer, Wells Fargo Private Bank, and Head of Global Alternative Investments for Wells Fargo Investment Institute, talks about four alternative investment strategies — equity hedge, relative value, event driven, and macro — that may help unlock value or complement traditional equity and fixed income allocations.

“These four strategies have historically helped to generate superior risk-adjusted returns,” says Taback, adding that these strategies often have lower correlation to traditional investments, meaning they have shown the ability to potentially produce greater returns with less volatility. “The potential benefit is being able to participate in upward-moving markets while being strategic in challenging markets, and being able to utilize additional tools, which are not readily available with traditional equity and fixed-income investments, to help achieve those objectives.”

Equity hedge
Overview: Identifies opportunities in the investable equity universe through a combination of traditional purchases and short sales.

Equity hedge strategy, explains Taback, maintains long and short positions in primarily equity and equity-derivative securities. It’s also known as long/short equity for this reason — investors can buy long equities, expecting their value to increase, or sell short equities, expecting their value to decrease. Typically, these strategies focus on the potential gains of the long-term play, says Taback, “with that long exposure slightly offset by the exposure on the short.”

Key terms

  • Net exposure: The difference between a fund’s long position and its short position. If 60 percent of a fund is in long positions and 40 percent is short, for example, then the fund’s net exposure is 20 percent.
  • Short selling: The selling of a security that the seller does not own, or any sale that’s completed by the delivery of a security borrowed by the seller. Short sellers assume that they’ll be able to buy the stock in the future at a lower price than the price at which they sold short.

Relative value
Overview: More conservative than equity hedge; focuses on fixed income and loan markets.

“This strategy is predicated on the realization of a small valuation discrepancy between multiple securities,” says Taback. Similar to an equity hedge, investors typically hold both long and short positions in an attempt to avoid exposure to volatility.

Key terms

  • Arbitrage: Let’s say you buy apples at Sally’s Farmers Market for $1 a pound, and then resell them at Sam’s Farmers Market for $2 a pound — that’s the basic premise of relative value arbitrage, or simultaneously selling one instrument while buying another to take advantage of price differentials.
  • Investing in pairs: Purchasing two securities in the same sector, with a long position in one and a short position in the other, hoping that the long position will provide gains to offset any losses in the short position.

Event Driven
Overview: Investing with a focus toward “catalyst” events, such as company spinoffs, mergers and acquisitions, or security issuance. For example, you might invest in a security with the expectation of influencing the management or strategy of a company.

Often, investors see opportunities to use their experience to help a company succeed. The typical event-driven move, according to Taback, is to purchase a large position in a company’s stock. By gaining a voice with management or the board of directors, the investor can recommend ways to better position the company for growth and stock price appreciation.

Key terms

  • Shareholder value: A firm’s proven performance – growing earnings, earning dividends, and increasing share price.
  • Intrinsic value (true value): This valuation of a company or an asset takes into account both tangible and intangible factors – including talent and potential for growth.
  • Exploiting price inefficiencies: Due to market fluctuations, stocks may be undervalued or overvalued at any given point. Investors generally have a very short timeframe to act on any price inefficiencies.

Overview: Strategy based on economic fundamentals and historical performance; adds diversification.

The macro strategy tends to perform particularly well in highly volatile environments. It tracks upward and downward movements in underlying economic variables and the impact these have on equity, fixed income, credit, hard currency, and commodity markets around the world. For example, if an investor sees economic data suggesting a country is going into recession, he or she may adjust investments to underweight securities in that country.

Key terms

  • Directional trading: Making long or short plays depending on the investor’s idea of where the market or security is heading in the short term.
  • Non-directional trading: Investing based on relative value principles rather than market shifts.

The takeaway: Why your investment professional may suggest exploring alternative strategies

  • Greater potential for diversification to help “smooth the ride” for investors especially during periods of market volatility
  • Historically low or non-correlation to traditional investments
  • Potential to minimize market cycle peaks and troughs
  • Exposure to a broader range of investment opportunities and strategies not broadly available
  • Potential for improved risk-adjusted returns
  • Diversified income streams (for investors seeking income)

“It’s important for investors to work with their investment professionals to understand alternative investments and how they can complement their long-term goals,” says Taback.

“There are also considerations that investors will need to understand before deciding if alternative strategies are right for their portfolios, such as different investment risk considerations, liquidity considerations, and, depending on the strategies/funds used, potentially tax-reporting considerations.”

Sarah Tuff Dunn is a frequent contributor to Conversations. She also writes for The New York Times, Men's Journal, Runner's World, and Women's Health.

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Alternative investments are not suitable for all investors and are available only to persons who are “accredited investors” or “qualified purchasers” within the meaning of U.S. securities laws. They are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. While investors may potentially benefit from the ability of alternative investments to potentially improve the risk-reward profiles of their portfolios, the investments themselves can carry significant risks. Alternative investment strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.

The information and opinions in this publication were prepared by Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wealth Management’s opinion as of the date of this publication and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this publication. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this publication.

Global Alternative Investments (“GAI”) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. Global Alternative Investment Services, Inc. is a registered broker‐dealer that acts as placement agent for certain funds and provides wholesaling support services to GAI.


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