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Multi-Strategy Hedge Funds - Strategy Outline
Eric Starr, Starr Capital Management
March 2004

The investment objective of multi-strategy hedge funds is to deliver consistently positive returns regardless of the directional movement in equity, interest rate or currency markets. In general, the risk profile of the multi-strategy classification is significantly lower than equity market risk. By definition, multi-strategy funds engage in a variety of investment strategies. The diversification benefits help to smooth returns, reduce volatility and decrease asset-class and single-strategy risks. Strategies adopted in a multi-strategy fund may include, but are not limited to, convertible bond arbitrage, equity long/short, statistical arbitrage and merger arbitrage.

Where did multi-strategy come from?

The extensive growth in hedge funds resulted from the migration of talented and entrepreneurial investment professionals from large asset management firms to independent, nimble, specialised firms. The skill sets developed at the large, traditional asset management companies could be better put to use in specialised strategies that removed traditional market risk and provided investors with absolute returns. Many of these specialists built successful hedge fund businesses centred on a core competency. As these specialist managers demonstrated the value of their strategy by generating high, risk-adjusted returns, the demand for their expertise grew. Managers were faced with a choice: close their funds to new investors, or find new ways to increase fund capacity. This search for capacity resulted in the launch of new funds with different strategies. In some cases, managers developed their own expertise in a new discipline, while others chose to add talented professionals to the existing staff, introducing additional expertise to the mix. The increased strategy scope of hedge fund managers gave rise to the multi-strategy hedge fund category.

What are the benefits of a multi-strategy fund?

The value of diversification in an investment portfolio has been well documented over the years. Shifting risk to more than one fund and/or strategy reduces the risk of the overall investment programme. The value in multi-strategy funds is providing the hedge fund manager with the flexibility to capitalise on the best opportunities in his varied skill set. Single-strategy funds are limited in the scope of their investment opportunities. When the inefficiencies in a specific expertise of a single-strategy fund wane, managers may reduce exposure by shifting into cash or remain invested in sub-optimal opportunities. Multi-strategy funds can allocate capital away from less-attractive strategies to those that offer superior opportunities. Moreover, multi-strategy funds can offer investors considerable capacity as investor capital is allocated across several strategies.

Multi-strategy funds are not managed by those with merely mediocre skills in a variety of strategies. Rather, successful multi-strategy managers have developed "best of breed" investment programmes in each of his strategies. Flexibility, capacity and high risk-adjusted returns are some of the benefits of multi-strategy funds.

What are the unique risks to multi-strategy funds?

Seldom will multi-strategy funds be the best performing category of hedge funds over a short-term time horizon. Diversification of strategies will water down the returns of a single strategy during a very "hot" period. An example might be if convertible bond arbitrage performs exceptionally well during a 12-month period, while equity long/short delivers acceptable returns. Convertible bond arbitrage managers will outperform multi-strategy managers who engage in both disciplines. During a longer time period, when convertible-bond arbitrage falls out of favour while equity long/short performs very well, multi-strategy managers may outperform convertible bond funds but underperform equity long/short managers. In the long term, however, the consistency and performance of multi-strategy funds should prove their worth, delivering low volatility, and high risk-adjusted returns both in absolute and relative terms.

Multi-strategy funds can offer investors access to a variety of strategies, provide considerable capacity and enhance the risk-adjusted returns of a diversified or concentrated investment portfolio.


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