Investments, tenth edition

   Directional and Nondirectional Strategies 

    Directional  strategies    are easy to understand. They are simply bets that one sector or 

another will outperform other sectors of the market. 

 In contrast,    nondirectional  strategies    are usually designed to exploit temporary misalign-

ments in security valuations. For example, if the yield on corporate bonds seems abnormally 

high compared to that on Treasury bonds, the hedge fund would buy corporates and short sell 

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Hedge Fund Strategies  

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Treasury securities. Notice that the fund is  not  betting on broad movements in the entire bond 

market: It buys one type of bond and sells another. By taking a long corporate–short Treasury 

position, the fund hedges its interest rate exposure while making a bet on the  relative   valua-

tion across the two sectors. The idea is that when yield spreads revert back to their “normal” 

relationship, the fund will profit from the realignment regardless of the general trend in the 

level of interest rates. In this respect, it strives to be    market  neutral,      or hedged with respect 

to the direction of interest rates, which gives rise to the term “hedge fund.” 

 Nondirectional strategies are sometimes further divided into  convergence  or  relative 

value  positions. The difference between convergence and relative value is a time horizon at 

which one can say with confidence that any mispricing ought to be resolved. An example 

of a convergence strategy would entail mispricing of a futures contract that must be cor-

rected by the time the contract matures. In contrast, the corporate versus Treasury spread 

we just discussed would be a relative value strategy, because there is no obvious horizon 

during which the yield spread would “correct” from unusual levels. 

 

 We can illustrate a market-neutral position with a strategy used extensively by several 

hedge funds, which observed that newly issued or “on-the-run” 30-year Treasury bonds 

regularly sell at higher prices (lower yields) than 29½-year bonds with almost identi-

cal duration. The yield spread presumably is a premium due to the greater liquidity of 

the on-the-run bonds. Hedge funds, which have relatively low liquidity needs, therefore 

buy the 29½-year bond and sell the 30-year bond. This is a hedged, or market-neutral, 

position that will generate a profit whenever the yields on the two bonds converge, as 

typically happens when the 30-year bonds age, are no longer the most liquid on-the-run 

bond, and are no longer priced at a premium. 

 Notice that this strategy should generate profits regardless of the general direction of 

interest rates. The long-short position will return a profit as long as the 30-year bonds 

underperform the 29½-year bonds, as they should when the liquidity premium dissi-

pates. Because the pricing discrepancies between these two securities almost necessarily 

 must  disappear at a given date, this strategy is an example of convergence arbitrage. 

While the convergence date in this application is not quite as definite as the maturity of 

a futures contract, one can be sure that the currently on-the-run T-bonds will lose that 

status by the time the Treasury next issues 30-year bonds.