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### Summary

### Summary

In today's volatile markets, managing risk is more important than ever. Investors are looking for downside protection while maintaining good returns--and market-neutral investing has become one of the hottest methods to meet that need. In this book, industry expert Joseph G. Nicholas explores new approaches to return enhancement and risk reduction through market-neutral strategies.

Market-neutral investments are attractive because they have produced substantially better risk-adjusted returns than the market during the past ten years. The complexities created by the combination of longs, shorts, and leverage, however, make market-neutral strategies very different from conventional investments. Getting to know how these strategies work involves breaking them down into their basic components and then examining how those parts interact as a system with specific behavior characteristics. This book examines eight key strategies, revealing the source of their past returns and giving the investor tools with which to measure the possibility of repeat performance.

Nicholas draws extensively on his company's database of over three thousand hedge funds and from the daily portfolio analysis conducted for hedge fund portfolios. He has also incorporated extensive input and actual investment examples provided by managers and practitioners of each of the strategies discussed in the book.

This is the one book that looks at market-neutral strategies head-on, assessing those that have worked and some notable ones that have failed--and explaining why. Clear, insightful, and illustrated with numerous charts and graphs, Market-Neutral Investing is an invaluable guide for professional investors.

### Author Notes

Joseph G. Nicholas, JD is founder and chairman of HFR Group, LLC, which includes HFR Asset Management, LLC, a fund-of-funds management company and Hedge Fund Research, Inc., a leading supplier of hedge fund data. Author of Investing in Hedge Funds and Hedge Fund of Funds Investing, he is a frequent lecturer and media expert on topics relating to alternative investments.

### Table of Contents

Acknowledgments | p. xvii |

Foreword | p. xix |

Introduction | p. 1 |

1 Investing in Relationships | p. 5 |

What Is Market Neutral? | p. 5 |

Basic Concepts | p. 10 |

Relationship Investing | p. 12 |

Understanding Market-Neutral Approaches | p. 13 |

2 Developments in the Hedge Fund Industry | p. 19 |

Hedge Fund Industry Assets | p. 20 |

Hedge Fund Investors | p. 22 |

Hedge Fund Strategies | p. 24 |

3 Making an Investment in Market-Neutral Strategies | p. 27 |

Linear Analysis of Returns | p. 28 |

Reducing Exposure to Risk | p. 35 |

Market-Neutral and Hedged Strategies | p. 40 |

Convertible Arbitrage | p. 40 |

Fixed-Income Arbitrage | p. 42 |

Mortgage-Backed Securities Arbitrage | p. 43 |

Merger Arbitrage | p. 45 |

Equity Hedge | p. 46 |

Equity Market-Neutral and Statistical Arbitrage | p. 48 |

Relative Value Arbitrage | p. 51 |

Achieving Superior Risk-Adjusted Returns | p. 52 |

Assessing the Risks | p. 52 |

Transparency | p. 54 |

Focusing on the Underlying Strategies | p. 55 |

4 Convertible Arbitrage | p. 57 |

Convertible Bond Valuation | p. 58 |

Statistical Advantage | p. 58 |

Convertible Valuation Components | p. 59 |

Convertible Arbitrage Approaches | p. 66 |

Quantitative Screens | p. 66 |

Kinds of Hedges | p. 66 |

Setting Up a Market-Neutral Hedge | p. 67 |

Setting up a Bullish Hedge | p. 71 |

Setting up a Bearish Hedge | p. 72 |

Risks and Risk Control | p. 73 |

Fundamental Analysis | p. 73 |

Hedge Analysis | p. 75 |

Portfolio Construction | p. 76 |

Liquidity | p. 78 |

Leverage | p. 78 |

Source of Return | p. 79 |

Convertible Bond Market History | p. 80 |

Recent Growth and Developments in Convertible Arbitrage | p. 82 |

Performance in Adverse Market Conditions | p. 82 |

Historical Examples | p. 84 |

5 Fixed-Income Arbitrage | p. 89 |

Fixed-Income Arbitrage Approaches | p. 91 |

Basis Trades | p. 91 |

Asset Swaps | p. 93 |

TED Spreads | p. 93 |

Yield Curve Arbitrage | p. 96 |

Relative Value Trades | p. 100 |

Risks and Risk Control | p. 101 |

Risks | p. 101 |

Measuring and Controlling Interest Rate Risk | p. 105 |

Sources of Return | p. 107 |

Financing | p. 108 |

Repurchase Agreements | p. 108 |

Technology | p. 108 |

Liquidity | p. 109 |

Events | p. 109 |

Manager Skill and Hard Work | p. 110 |

Growth and Recent Developments in Fixed-Income Arbitrage | p. 110 |

6 Mortgage-Backed Securities Arbitrage | p. 119 |

Mortgage-Backed Structures or Sectors (Types of MBS Instruments) | p. 121 |

Mortgage-Backed Securities' Evolution | p. 121 |

Pass-Throughs | p. 124 |

Basic Collateralized Mortgage Obligations (CMOs) | p. 125 |

CMO Tranches | p. 128 |

Valuation Methods | p. 132 |

Option-Adjusted Spreads | p. 132 |

Information Systems | p. 133 |

Risks and Risk Control | p. 133 |

Duration | p. 134 |

Effective and Partial Duration | p. 135 |

Parallel and Rotational Shifts of the Yield Curve | p. 136 |

Convexity | p. 136 |

Prepayment Duration | p. 136 |

Leverage | p. 136 |

Pricing | p. 137 |

Source of Return | p. 137 |

Valuation Models | p. 138 |

Leverage | p. 138 |

Liquidity | p. 139 |

Financing | p. 139 |

Hedging Techniques | p. 139 |

Recent Developments in MBS Arbitrage | p. 140 |

7 Merger Arbitrage | p. 145 |

Merger Arbitrage Approaches | p. 148 |

Cash Mergers or Tender Offers | p. 148 |

Stock Swap Mergers | p. 148 |

Stock Swap Mergers with a Collar | p. 151 |

Multiple Bidder Situations | p. 157 |

Leveraged Buyouts and Hostile Takeovers | p. 162 |

Risks | p. 166 |

Event Risk | p. 166 |

Deal Flow | p. 168 |

Liquidity | p. 168 |

Risk Control | p. 169 |

Diversification | p. 169 |

Leverage | p. 169 |

Source of Return | p. 169 |

Growth and Recent Developments in Merger Arbitrage | p. 170 |

Deal Flow and Other Factors Affecting Volume | p. 171 |

Stress Period: The Third Quarter of 1998 | p. 173 |

Returns | p. 176 |

8 Equity Hedge | p. 177 |

Investment Themes and Fundamental Analysis | p. 178 |

Investment Themes | p. 179 |

Fundamental Analysis | p. 180 |

Equity Hedge Approaches | p. 181 |

Quantitative vs. Qualitative Mix | p. 181 |

Universe of Stocks | p. 182 |

Style | p. 182 |

Liquidity | p. 188 |

Net Market Exposure | p. 189 |

Research | p. 190 |

Leverage | p. 191 |

Risks and Risk Control | p. 192 |

Stock-Picking Risk | p. 192 |

Market Risk | p. 193 |

Universe of Stocks | p. 193 |

Diversification | p. 194 |

Sell Disciplines | p. 195 |

Leverage | p. 195 |

Source of Return | p. 196 |

Recent Growth and Developments in Equity Hedge Investing | p. 197 |

9 Equity Market-Neutral and Statistical Arbitrage | p. 203 |

Equity Market-Neutral Approaches | p. 205 |

Initial Screen: Universe of Investable Stocks | p. 205 |

Stock Selection | p. 208 |

Mean Reversion-Based Approaches | p. 213 |

Risks and Risk Control | p. 217 |

Portfolio Construction and Optimization | p. 217 |

Manager Styles--Putting It All Together | p. 221 |

Source of Return | p. 222 |

Recent Growth and Developments in Equity Market-Neutral Investing | p. 223 |

10 Relative Value Arbitrage | p. 231 |

Relative Value Arbitrage Approaches | p. 232 |

Convertible Arbitrage | p. 233 |

Merger Arbitrage | p. 234 |

Equity Statistical Arbitrage | p. 236 |

Pairs Trading | p. 237 |

Fixed-Income Arbitrage | p. 237 |

Options and Warrants Trading | p. 239 |

Capital Structure Arbitrage | p. 240 |

Regulation D (Structured Discount Convertible) Arbitrage | p. 241 |

Risks and Risk Control | p. 241 |

Strategy Mix | p. 242 |

Strategy Weightings | p. 242 |

Source of Return | p. 243 |

Growth and Recent Developments in Relative Value Arbitrage | p. 243 |

Afterword | p. 247 |

Glossary | p. 249 |

Index | p. 255 |