Investor's wiki

Relative Value Fund

Relative Value Fund

What Is a Relative Value Fund?

A relative value fund is a actively managed investment fund that tries to take advantage of brief differences in the prices of related securities. This approach to investing is frequently utilized by hedge funds.

A common strategy while overseeing relative value funds is called pairs trading, which comprises of starting a long and short position for a pair of assets that are exceptionally connected. Now and again, relative value funds can produce risk-free profits through the method involved with buying and selling the two distinct securities simultaneously, which is called arbitrage.

Understanding Relative Value Funds

While most investment funds assess investment candidates separately, relative value funds survey candidates by contrasting their prices with those of related assets, or benchmarks. For example, a relative value fund could assess the engaging quality of a technology company by contrasting its price and fundamentals relative to different companies in its industry, though most investors would probably assess the company on its individual merits. The goal of relative value funds is to distinguish assets that are mispriced according to one another.

Relative value funds are regularly hedge funds, which frequently look to utilize leverage to enhance their returns. Such funds will utilize margin trading to take long positions on securities they consider undervalued, while simultaneously taking short positions on related securities they consider overvalued.

Whether or not a security is undervalued or overvalued is speculative, and investors will endeavor to determine this utilizing a wide range of approaches. A common strategy is to depend on reversion to the mean.

At the end of the day, investors will frequently expect to be that, over the long haul, prices will return toward their long-term historical averages. In this manner, in the event that a given asset is costly relative to its historical level, it will be seen as a candidate for short selling. Those trading below historical levels, then again, will be seen as long candidates.

The most commonly utilized relative value strategy is pairs trading, however this approach is carried out in various ways by investors. A few investors will try to take advantage of various valuations between securities that are closely connected with one another, for example, contenders inside the oil and gas industry that are remembered for the S&P 500 Index.

Different investors could take on a macroeconomic approach, seeking to take advantage of mispricings between stocks, bonds, options, and currency futures relative to the performance of the countries where they are in operation.

This last option approach is as yet considered pairs trading, yet distinguishing the important correlative components and organizing the required transactions is considerably more complex in this scenario than in the more normal scenario of starting long and short positions in two related assets.

Real World Example of a Relative Value Fund

Assume you are the manager of a relative value fund that is seeking to take advantage of mispricings between connected securities. In carrying out this strategy, your firm purposes a scope of approaches, which fluctuate with respect to their risk-reward profile.

On the generally safe finish of the range are true arbitrage opportunities. Albeit these are rare, they offer the opportunity to profit with basically no risk and are consequently your firm's preferred type of activity. An illustration of this is that you are sometimes able to all the while buy and sell convertible debt instruments along with their underlying stock. In doing this, you are actually taking advantage of brief errors in their valuations.

On a more regular basis, your trades are more speculative. For example, you frequently short sell securities which are overvalued relative to their peer group, while adopting a long strategy with their undervalued peers. By making this determination, you are depending on the assumption that the past will repeat itself, and over the long haul, prices will return toward their historical mean or average.

Since it is basically impossible to know when this mean reversion will happen, it is workable for these inexplicable mispricings to persevere for long periods of time. This risk is accumulated even more when leverage is involved in view of the cost of interest and the risk of margin calls.

Features

  • Pairs trading is a common strategy of relative value funds where a long and short position is initiated for a pair of assets that are profoundly corresponded.
  • The funds use analysis to determine assuming that an asset is undervalued or overvalued and will buy or sell in like manner.
  • A relative value fund tries to take advantage of mis-pricings of related securities.