Relative value in its most broadest definition is a method of determining an the value of an asset by comparing it to similar assets. Intrinsic value on the other hand, takes the asset in question and attempts to make a valuation on internal factors without the need for other assets. The price earnings ratio, or PE multiple is a common method for performing this type of valuation in the stock market. On that note, a relative value fund is an investment fund that seeks to exploit differences in the prices of related securities.
By using the PE multiple as described above or any other method (often a proprietary algorithm), the fund manager attempts to value a range of securities in order to locate a mispricing. This is a common investment strategy used by hedge funds. In some cases, relative value funds can generate risk-free profits through the process of buying and selling the two different securities at the same time, which is called arbitrage.
Relative Value v's Stat Arb
A common name for this investment strategy is pairs trading. This consists of initiating a long and short position for a pair of assets that not only exhibit a high degree of cointegration but also demonstrate a logical reason why the business are related. Without this link, such as Coca-cola and Pepsi for instance, the trade will be based on a purely statistical analysis and would then move towards being a statistical arbitrage strategy.
Trading CFD’s is a popular way to execute these strategies as their zero commissions and tax free status appeals to investors. However, this type of trading strategy is not limited to stocks however and can be implements on a variety of assets including fixed income (see Fixed Income Relative Value Analysis: A Practitioners Guide to the Theory, Tools, and Trades), commodities and FOREX.
