Some hedge fund strategies don't depend on whether markets go up or down. Instead they look for prices that seem out of line with each other, or for corporate events, such as a takeover, that should move a price in a predictable way. These are relative value and event-driven strategies.
Both can produce steady-looking returns for long periods, followed by sharp losses when the expected relationship or event fails. Knowing why helps allocators judge the risk behind a smooth track record, and helps operations teams understand why these funds often carry leverage, derivatives and hedges that need careful tracking. This lesson explains both strategies and works through a merger arbitrage example step by step.
Relative value
Relative value strategies try to profit from price gaps between related securities. The manager buys the one that looks cheap, shorts the one that looks expensive, and waits for the gap to close. Because the two positions offset each other, the fund cares less about the direction of the market than about the relationship between the two prices.
Two common forms:
- Fixed income relative value. Bonds with very similar features sometimes trade at slightly different yields. For example, two government bonds maturing a few months apart may be priced a little out of line, perhaps because one is in heavier demand. The manager buys the cheaper bond, shorts the richer one, and profits if their prices converge. Similar trades are made between bonds and related futures or swaps.
- Convertible arbitrage. A convertible bond is a bond that the holder can exchange for a set number of the issuer's shares. Its price reflects both its value as a bond and the value of that right to convert. A convertible arbitrage fund commonly buys the convertible and shorts some of the issuer's stock. The short offsets much of the effect of share price moves, leaving the fund to earn the bond's interest and to profit if the convertible was priced cheaply compared with its parts.
The gaps involved are usually small. A mispricing of a fraction of a percent may be worth trading, but only if the position is large. So relative value funds commonly use leverage: they borrow, or use derivatives, to hold positions many times the size of their capital.
That creates the main risk. Gaps can widen before they close, especially in a market panic, when many investors want to sell the same things at once. A leveraged fund may then face margin calls from its prime broker and be forced to sell at the worst time, which can widen the gaps further. Lesson 3.2 explains how leverage can force selling.
Event-driven
Event-driven strategies trade on corporate events: mergers, spin-offs, restructurings and similar changes. The price of a security often moves in a predictable way if the event happens. The manager's job is to judge whether it will happen, when, and what the price will be if it doesn't.
The best-known event-driven strategy is merger arbitrage.
Worked example: merger arbitrage
When one company agrees to buy another, the target's shares usually jump but stay a little below the offer price until the deal closes. That gap is the spread. It exists because the deal might fail, because money is tied up until closing, and because many investors don't want to wait or take the risk. A merger arbitrageur buys the target's shares to earn the spread.
The following example is illustrative. Marlow Instruments, a fictional company, agrees to be bought by Castellan Industries for $50.00 a share in cash. After the announcement, Marlow's shares trade at $46.00. The deal is expected to close in about six months, once shareholders and regulators approve it.
If the deal closes
| Step | Working | Result |
|---|---|---|
| Offer price | Given | $50.00 |
| Current share price | Given | $46.00 |
| Spread per share | 50.00 − 46.00 | $4.00 |
| Return over six months | 4.00 ÷ 46.00 | 8.7% |
| Rough annualized return | 8.7% × 2 | ≈ 17% |
The return is measured against the $46.00 the fund pays, not the $50.00 offer. The annualized figure simply doubles the six-month return; it ignores compounding and assumes the deal closes on time. Delays reduce the annualized return even if the deal eventually completes.
If the deal breaks
Deals can fail: regulators may block them, financing may fall through, shareholders may vote them down, or the buyer may walk away. If Marlow's deal breaks, suppose its shares fall back to $36.00, roughly where they might have traded without the offer.
| Step | Working | Result |
|---|---|---|
| Current share price | Given | $46.00 |
| Price after a break | Assumed | $36.00 |
| Loss per share | 46.00 − 36.00 | $10.00 |
| Loss as a percentage | 10.00 ÷ 46.00 | 21.7% |
The possible loss, $10.00, is two and a half times the possible gain, $4.00.
What the market is implying
The price lets you work out the chance of completion the market is implying. Call that probability p. Ignoring time and costs, the expected gain and expected loss balance when:
- 4.00 × p = 10.00 × (1 − p)
- 4.00p + 10.00p = 10.00
- 14.00p = 10.00, so p = 10 ÷ 14 ≈ 71%
So the market is pricing a roughly 71% chance the deal completes. A merger arbitrageur buys when it believes the true chance is meaningfully higher, based on its own analysis of regulation, financing, shareholder support and the buyer's commitment.
Steady, until it isn't
This asymmetry explains the pattern of merger arbitrage returns. Most deals close, so a portfolio of them earns many small, steady gains. Then a deal breaks, and one loss can wipe out the gains from several successful deals. Deal breaks can also cluster, for example when markets fall sharply and financing becomes harder to obtain. A smooth track record may simply mean no large deal has broken yet.
Stock-for-stock deals
In some deals the buyer pays in its own shares instead of cash. Target shareholders receive a fixed number of acquirer shares for each target share. Here the arbitrageur commonly buys the target and shorts the acquirer in the matching ratio. If the acquirer's price moves, the long and short positions offset, and the fund still earns the spread when the deal closes. If the deal breaks, the fund can lose on both sides.
Special situations
Special situations covers other corporate events where the manager sees a mispricing. Common examples:
- Spin-offs: a company separates a division into a new, independently listed company. Some existing shareholders sell the new shares without much analysis, for example because it is too small for their mandate, which can leave them cheap.
- Restructurings: a company reorganizes its business or its debts, for example by selling divisions or swapping debt for equity. Lesson 2.4 covers distressed debt.
- Other events: share buybacks, changes to stock index membership, or pressure from shareholders pushing for change.
These positions depend on the event happening and on the market pricing it the way the manager expects. Timing is often uncertain.
Comparing the strategies
| Strategy | What the manager trades | What must happen to make money | Main risk |
|---|---|---|---|
| Fixed income relative value | Closely related bonds, futures or swaps | Price gaps narrow | Gaps widen while leverage forces selling |
| Convertible arbitrage | Long convertible, short the issuer's stock | Convertible's value is realized | Credit problems at the issuer; forced selling |
| Merger arbitrage | Long the target (short the acquirer in stock deals) | The deal closes on time | The deal breaks |
| Special situations | Securities affected by spin-offs, restructurings and other events | The event happens and is priced as expected | The event is delayed, changed or cancelled |
Key terms
- Relative value: a strategy that profits from price gaps between related securities, usually by buying one and shorting the other.
- Convertible bond: a bond that the holder can exchange for a set number of the issuer's shares.
- Convertible arbitrage: buying convertible bonds and shorting the issuer's stock to isolate the convertible's value.
- Event-driven: a strategy based on corporate events such as mergers, spin-offs and restructurings.
- Merger arbitrage: buying the shares of a takeover target to earn the gap to the offer price.
- Spread: in merger arbitrage, the difference between the offer price and the target's current share price.
- Deal break: the failure of an announced merger, which usually sends the target's shares down.
- Spin-off: the separation of a division into a new, independently listed company.
Key takeaways
- Relative value funds buy cheap and short expensive related securities; the gaps are small, so leverage is common and forced selling is the key risk.
- Merger arbitrage earns the spread to an offer price: $4.00 on $46.00 is 8.7% over six months, roughly 17% annualized.
- A deal break can cost far more than the spread: $10.00, or 21.7%, in the example, and the price implies about a 71% chance of completion.
- Merger arbitrage returns look steady until a deal breaks; in stock-for-stock deals, arbitrageurs commonly short the acquirer.
- Special situations trade events such as spin-offs and restructurings, where timing and outcome are uncertain.
This lesson is for educational purposes only and is not investment advice.