Diksia.com - Structured credit hedge funds are a type of alternative investment that focus on fixed-income securities and derivatives, such as bonds, loans, asset-backed securities, credit default swaps, and options. These funds aim to exploit inefficiencies and mispricings in the credit markets, as well as to hedge against various risks, such as interest rate, default, and liquidity risk. Structured credit hedge funds can offer investors diversification, higher returns, and lower volatility than traditional fixed-income investments, but they also entail higher complexity, fees, and risks.
In this article, we will explain what structured credit hedge funds are, how they operate, what are their main strategies, what are their advantages and disadvantages, and how to invest in them.
What are Structured Credit Hedge Funds?
Structured credit hedge funds are a subset of credit hedge funds, which are hedge funds that invest in fixed-income securities and their derivatives. Fixed-income securities are debt instruments that pay a fixed or variable interest rate, such as government bonds, corporate bonds, municipal bonds, and bank loans. Derivatives are financial contracts that derive their value from an underlying asset, such as a bond, a stock, or an index. Examples of derivatives include futures, options, swaps, and forwards.
Structured credit hedge funds specialize in a specific type of fixed-income securities and derivatives, known as structured credit. Structured credit refers to securities that are created by pooling and repackaging individual loans or bonds into new securities, known as asset-backed securities (ABS). ABS are then divided into different tranches, or slices, that have different risk and return profiles, depending on the seniority and credit quality of the underlying loans or bonds. Examples of ABS include mortgage-backed securities (MBS), collateralized debt obligations (CDO), collateralized loan obligations (CLO), and commercial mortgage-backed securities (CMBS).
Structured credit hedge funds use various strategies to generate returns from structured credit securities and derivatives, such as arbitrage, relative value, directional, and event-driven. These strategies involve buying and selling different tranches of ABS, as well as using derivatives to hedge or speculate on the movements of interest rates, credit spreads, default rates, and prepayment rates. Structured credit hedge funds also use leverage, or borrowed money, to amplify their returns and risks.
How do Structured Credit Hedge Funds Operate?
Structured credit hedge funds operate similarly to other hedge funds, but with some specific features. Hedge funds are pooled investment vehicles that are open to a limited number of accredited or institutional investors, such as wealthy individuals, pension funds, endowments, and foundations. Hedge funds are not subject to the same regulations and disclosure requirements as mutual funds or exchange-traded funds (ETFs), which gives them more flexibility and secrecy in their investment activities. Hedge funds typically charge a management fee, usually 2% of the assets under management (AUM), and a performance fee, usually 20% of the profits above a certain threshold, known as the hurdle rate or the high-water mark.
Structured credit hedge funds have some distinctive characteristics that set them apart from other hedge funds. First, structured credit hedge funds require a high level of expertise and sophistication, as structured credit securities and derivatives are complex and illiquid instruments that require extensive analysis and valuation. Structured credit hedge funds also need to have access to reliable data sources, sophisticated models, and specialized software to monitor and manage their portfolios. Second, structured credit hedge funds tend to have longer lock-up periods, or periods during which investors cannot withdraw their money, than other hedge funds.
This is because structured credit securities and derivatives are not easily traded or sold, and may take a long time to mature or unwind. Structured credit hedge funds may also impose gates, or limits on the amount of money that can be withdrawn at a given time, to prevent sudden and large redemptions that could disrupt their operations. Third, structured credit hedge funds tend to have higher fees than other hedge funds, as they incur higher costs and risks in their investment activities. Structured credit hedge funds may charge higher management fees, performance fees, or both, to compensate for their complexity and illiquidity.
What are the Main Strategies of Structured Credit Hedge Funds?
Structured credit hedge funds use various strategies to generate returns from structured credit securities and derivatives, depending on their objectives, risk appetite, and market conditions. Some of the main strategies are:
Arbitrage
This strategy involves exploiting price differences or misalignments between two or more related securities or markets, such as different tranches of the same ABS, or the cash and synthetic markets of structured credit. For example, a structured credit hedge fund may buy a cheap tranche of a CLO and sell a more expensive tranche of the same CLO, or buy a CLO tranche in the cash market and sell a credit default swap (CDS) on the same tranche in the synthetic market. The fund would profit from the convergence of the prices or spreads of the securities or markets, while hedging against the risk of default or interest rate movements.
Relative value
This strategy involves identifying and exploiting valuation discrepancies or mispricings between two or more securities or markets that have similar characteristics or are expected to behave similarly, such as different ABS issued by the same or similar entities, or different sectors or regions of the structured credit market. For example, a structured credit hedge fund may buy an undervalued tranche of a CMBS and sell an overvalued tranche of another CMBS, or buy a tranche of a CLO that is expected to outperform and sell a tranche of another CLO that is expected to underperform. The fund would profit from the divergence of the prices or spreads of the securities or markets, while hedging against the risk of default or interest rate movements.
Directional
This strategy involves taking a view on the direction of the prices or spreads of structured credit securities or markets, based on macroeconomic, fundamental, technical, or other factors, and positioning accordingly. For example, a structured credit hedge fund may buy a tranche of a CDO that is expected to appreciate due to improving credit quality or market sentiment, or sell a tranche of a MBS that is expected to depreciate due to deteriorating credit quality or market sentiment. The fund would profit from the movement of the prices or spreads of the securities or markets, but would also be exposed to the risk of default or interest rate movements.
Event-driven
This strategy involves taking advantage of specific events or situations that affect the prices or spreads of structured credit securities or markets, such as mergers and acquisitions, restructurings, refinancings, ratings changes, litigation, or regulatory changes. For example, a structured credit hedge fund may buy a tranche of a CLO that is expected to benefit from a merger or acquisition of one of its underlying borrowers, or sell a tranche of a MBS that is expected to suffer from a refinancing or prepayment of one of its underlying mortgages. The fund would profit from the impact of the events or situations on the prices or spreads of the securities or markets, but would also be exposed to the risk of default or interest rate movements.
What are the Advantages and Disadvantages of Structured Credit Hedge Funds?
Structured credit hedge funds can offer investors several advantages and disadvantages, depending on their goals, risk tolerance, and time horizon.
Some of the advantages are:
- Diversification: Structured credit hedge funds can provide diversification benefits to investors, as they have low or negative correlation with other asset classes, such as equities, commodities, or traditional fixed income. This means that structured credit hedge funds can reduce the overall risk and volatility of a portfolio, and enhance its risk-adjusted returns, especially during periods of market stress or turmoil.
- Higher returns: Structured credit hedge funds can generate higher returns than other asset classes, as they can capture the risk premia, or the excess returns, associated with investing in structured credit securities and derivatives, which are often considered risky and complex by the market. Structured credit hedge funds can also use leverage, or borrowed money, to amplify their returns and risks.
- Lower volatility: Structured credit hedge funds can have lower volatility than other asset classes, as they can use various hedging techniques, such as short selling, derivatives, or diversification, to reduce their exposure to market fluctuations, such as interest rate, default, or liquidity risk. Structured credit hedge funds can also benefit from the stability and predictability of the cash flows of structured credit securities, which are often fixed or variable interest payments.
Some of the disadvantages are:
- Higher complexity: Structured credit hedge funds are highly complex and sophisticated, as they involve investing in structured credit securities and derivatives, which are difficult to understand, analyze, and value. Structured credit hedge funds also require a high level of expertise and sophistication, as they use various strategies, models, and software to monitor and manage their portfolios. Structured credit hedge funds are also subject to various risks and uncertainties, such as model risk, operational risk, or counterparty risk.
- Higher fees: Structured credit hedge funds charge higher fees than other asset classes, as they incur higher costs and risks in their investment activities. Structured credit hedge funds typically charge a management fee, usually 2% of the assets under management (AUM), and a performance fee, usually 20% of the profits above a certain threshold, known as the hurdle rate or the high-water mark. These fees can reduce the net returns of investors, especially if the fund underperforms or loses money.
- Lower liquidity: Structured credit hedge funds have lower liquidity than other asset classes, as they involve investing in structured credit securities and derivatives, which are not easily traded or sold, and may take a long time to mature or unwind. Structured credit hedge funds also have longer lock-up periods, or periods during which investors cannot withdraw their money, than other hedge funds. This means that investors may not be able to access their money when they need it, or may have to pay a penalty or a discount to do so. Structured credit hedge funds may also impose gates, or limits on the amount of money that can be withdrawn at a given time, to prevent sudden and large redemptions that could disrupt their operations.
How to Invest in Structured Credit Hedge Funds?
Investing in structured credit hedge funds is not easy or suitable for everyone, as it requires a high level of capital, expertise, and risk tolerance. Investors who are interested in structured credit hedge funds should consider the following factors:
- Eligibility: Structured credit hedge funds are open to a limited number of accredited or institutional investors, who have to meet certain criteria, such as net worth, income, or assets. Investors also have to pass a due diligence process, which may involve providing personal and financial information, signing legal documents, and paying fees.
- Performance: Structured credit hedge funds do not have a standard benchmark or index to measure their performance, as they use different strategies, securities, and markets. Investors have to rely on the fund’s own reports and disclosures, which may not be audited or verified by a third party. Investors also have to be aware of the fund’s fees, which can reduce the net returns of the fund. Investors should compare the fund’s performance with its peers, its objectives, and its risks, as well as with other asset classes.
- Risk: Structured credit hedge funds are subject to various risks, such as market risk, credit risk, interest rate risk, liquidity risk, leverage risk, model risk, operational risk, and counterparty risk. These risks can result in losses, volatility, or illiquidity of the fund. Investors should understand the fund’s risk profile, risk management, and risk exposure, as well as their own risk appetite and tolerance. Investors should also diversify their portfolio across different funds, strategies, securities, and markets, to reduce their overall risk.
- Transparency: Structured credit hedge funds are not subject to the same regulations and disclosure requirements as mutual funds or ETFs, which gives them more flexibility and secrecy in their investment activities. Investors may not have access to the fund’s portfolio, strategy, valuation, or performance, or may have to sign a non-disclosure agreement to do so. Investors may also have limited or delayed communication with the fund’s manager or staff, or may have to rely on intermediaries, such as brokers or consultants, to access the fund. Investors should seek as much information and clarity as possible from the fund, and verify the accuracy and reliability of the information.
Structured credit hedge funds are a type of alternative investment that focus on fixed-income securities and derivatives, such as bonds, loans, asset-backed securities, credit default swaps, and options. These funds aim to exploit inefficiencies and mispricings in the credit markets, as well as to hedge against various risks, such as interest rate, default, and liquidity risk. Structured credit hedge funds can offer investors diversification, higher returns, and lower volatility than traditional fixed-income investments, but they also entail higher complexity, fees, and risks. Investors who are interested in structured credit hedge funds should consider their eligibility, performance, risk, and transparency, and consult a professional advisor before investing.
