Relative Value Strategy Explained Simply

A relative value strategy is a type of investment approach that focuses on identifying mispriced securities by comparing their prices to their intrinsic values.

This strategy involves analyzing the relationships between different securities, such as bonds and stocks, to identify opportunities for profit.

The goal is to buy undervalued securities and sell overvalued ones, taking advantage of the price discrepancies.

Relative value strategies can be used in various markets, including fixed income and equity markets.

A relative value strategy is all about finding undervalued assets and betting on their future growth.

By analyzing market inefficiencies, you can identify mispriced securities and make informed investment decisions.

In a relative value strategy, the goal is to generate returns by exploiting these market inefficiencies, rather than relying on the overall market trend.

A key aspect of this strategy is to identify the underlying drivers of value, such as earnings growth, cash flow, or industry trends.

You can use metrics like the price-to-earnings ratio (P/E) to gauge the relative value of different stocks within the same industry.

For example, if a company's P/E ratio is significantly lower than its peers, it may be undervalued and worth considering for investment.

Another important consideration is the liquidity of the assets, as illiquid securities can be more difficult to sell quickly if needed.

By balancing these factors, you can create a diversified portfolio that takes advantage of relative value opportunities.

A well-executed relative value strategy can help you generate consistent returns over the long term.

Fixed-income arbitrage strategies, like yield curve trades and carry trades, are a type of relative value strategy.

These strategies involve long and short positions at different points on the yield curve, driven by relative mispricing opportunities resulting from perceptions and forecasts of macroeconomic conditions.

The goal is to profit as the mispricing reverts to normal within a targeted time frame, typically with substantial leverage to amplify potential profits.

A classic example of a carry trade involves buying lower liquidity, off-the-run government securities and selling higher liquidity, duration-matched, on-the-run government securities.

The critical concern in this strategy is liquidity risk, which can lead to significant losses if a temporary negative price shock triggers margin calls.

If the strategy unfolds as expected, it generates a positive carry and profit from spread narrowing, similar to a short put option payoff profile.

However, if the spread unexpectedly widens, the payoff becomes negative, highlighting the importance of managing risk and avoiding excessive leverage.

Relative value funds are actively managed investment funds that seek to exploit temporary differences in the prices of related securities.

These funds often use leverage to amplify their returns, and typically take long positions on undervalued securities while short selling overvalued ones.

The goal of relative value funds is to identify assets that are mispriced in relation to each other, and they often rely on reversion to the mean to make investment decisions.

Reversion to the mean is a common strategy where investors assume that, in the long run, prices will revert toward their long-term historical averages.

Investors will often view a security as a candidate for short selling if it is expensive relative to its historical level, and as a long candidate if it is trading below historical levels.

Relative value funds can generate risk-free profits through the process of buying and selling two different securities at the same time, which is called arbitrage.

Arbitrage opportunities are rare, but they offer the opportunity to profit with practically no risk, making them the preferred type of activity for many relative value funds.

A common strategy for managing relative value funds is called pairs trading, which involves initiating a long and short position for a pair of highly correlated assets.

Pairs trading can be implemented in a variety of ways, including exploiting different valuations between securities that are closely related to each other, such as competitors within the same industry.

Volatility trading is all about finding price differences between assets and profiting from them while minimizing risk. This strategy involves buying cheap exposures and selling expensive exposures at the same time, essentially hedging out main directional market risks.

Relative value volatility traders provide liquidity for end-users of options, redistributing risk from areas where options are abundant to those in high demand. For example, if pension funds buy puts on Mastercard, it may increase the implied volatility prices of the options, allowing volatility traders to sell these overpriced options and hedge by buying cheaper options elsewhere.

Finding these opportunities can be challenging due to constantly changing market conditions, requiring traders to constantly monitor options prices and understand why dislocations occur.

Leverage Usage plays a significant role in Volatility Trading, especially in hedge funds that frequently employ substantial leverage.

Elevated leverage is often used, but the degree of leverage tends to decrease as the complexity of the products involved increases.

Hedge funds use collateralized repurchase agreements facilitated by prime brokers to achieve the desired level of leverage. These agreements come with associated leverage "haircuts" that vary based on the types of securities involved.

The haircut represents the prime broker's precaution against market volatility and potential difficulties selling posted collateral during market turbulence.

The types of securities involved determine the size of the haircut, which can impact the overall leverage of a hedge fund.

Volatility trading is a strategy that involves buying cheap exposures and selling expensive exposures at the same time. This hedges out the main directional market risks that would otherwise be present in a traditional investment portfolio.

Relative value strategies allow investors to benefit from price differences between different assets while mitigating their risk exposure to changing market conditions. For example, if Visa is overpriced compared to Mastercard, a trader could take a short position in V and buy MA as a hedge.

Market conditions are constantly changing, making it difficult for traders to find relative value volatility trades. Traders must constantly watch options prices and try to understand why dislocations (price inefficiencies) pop up.

Volatility traders provide an important service to the market by providing liquidity for end-users of options and redistributing risk from areas where options are in abundance to those in high demand. This can be seen in the example of pension funds buying puts on Mastercard, increasing the implied volatility prices of the options.

The need for users of options to manage their risks creates a demand for volatility traders to sell overpriced options and hedge by buying cheaper options elsewhere. This is made possible by the supply and demand that sets the market prices of options.

Investors can find good trades by tracking dislocations in option prices over time and assessing each opportunity. For example, when a fund begins selling covered calls on a long, large-cap equity portfolio, the prices of options within that universe decrease significantly.

Discretionary and systematic trading exist on a spectrum, with most volatility managers lying somewhere in between. Options aren't linear products like stocks or futures, making full automation difficult and prone to small mistakes leading to big problems.

Relative value volatility trading involves buying cheap exposures and selling expensive exposures at the same time, which hedges out directional market risks.

To find good trades, you need to track dislocations over time and assess each opportunity. This involves quantitative analysis of option prices and understanding why dislocations pop up.

Dislocations can be caused by large funds selling calls on their large-cap energy names, driving down their prices. For example, pension funds might be extremely popular with pension funds for a couple of years before falling out of favor.

A savvy investor has to understand when there is an opportunity and when it has dried up. This requires constant monitoring of options prices and market conditions.

To trade effectively, you need to provide liquidity for end-users of options and redistribute risk from areas where options are in abundance to those in high demand. This can be done by selling overpriced options and hedging by buying cheaper options elsewhere.

Here are some strategies that form a relative value fund's portfolio: