It’s one of the least promoted hedge fund strategies. Yet, some 25 percent of hedge fund managers may now be using it. 

It helps hedge fund managers diversify and move further afield from correlations to mainstream indices, and reduce overall portfolio risk.

So what is this mysterious strategy? It’s called event-driven, and it targets financial events such as bankruptcies, recapitalizations, spin-offs, asset sales, leadership transitions, litigation and regulatory changes that can suddenly kick-start a company’s stock price, up or down. There are scores of variations on event-driven, all of which have little correlation with the broader markets, according to a recent article in the Financial Times.

The most common event-driven strategy is Mergers & Acquisitions arbitrage, where a hedge fund shorts the shares of an acquiring company and buys shares in the target company. However, if the chances of a deal closing are uncertain, then a hedge fund manager may employ the opposite approach.

At times when M&A activity is scarce, there are event-driven strategies that can take advantage of other opportunities, too, such as pouncing on distressed companies. For example, when a company has emerged from bankruptcy protection and its debt has been converted to equity. At times like these, the re-listing of the stock and the return of analyst coverage can spark quick appreciation of the stock.

Event-driven strategies have performed fairly well over the past few years, in line with the broader hedge fund market. Event-driven strategies returned 11.74 percent in 2010, versus 10.28 percent for all hedge funds, according to data from Hedge Fund Research.

But some industry insiders fear that the strategy may be getting a little overheated, as more and more funds employ it. There are even exchange-traded funds on the market now that reportedly replicate M&A arbitrage.

“We like the strategy in principle but we started getting out of it in 2007 and early 2008. We were concerned about lurking beta in the strategy and the low M&A volumes so far this year have not changed our view,” said Stephen Harper, chief executive of Saguenay Strathmore Capital (SSC), a fund of hedge funds manager.

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