Hedge Fund Strategies

As we've explored in the previous lessons, hedge funds cannot be described as a single asset class. Hedge funds invest in a diverse group of strategies that differ considerably according to the method of portfolio construction and risk management techniques. In this section, we'll find out more about the individual strategies.

While no two hedge funds are the same, most generate their returns by investing in line with a specific top-level strategy: equity, relative value, event driven, macro, credit, niche, and alternative risk premia.

Equity Strategies

The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued.

Equities’ correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds. They are highly susceptible to systematic risk factors (i.e. risks associated with the broader stock market), for example inflation, which can negatively impact future cash flows. Investors in equity strategies hedge funds also need to consider the risks associated with correlation to other equity investments held within their portfolio.

Equity strategies can be undertaken in a variety of ways depending on the desired amount of market exposure. Explore the drop-down to find out more.

Long/Short Equity

Long/short equity funds favor more versatile asset exposure. The perception is that they operate 50% long and 50% short, but they usually lean more toward net long.

Market-Neutral

Market-neutral funds seek to exploit differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, etc. This strategy creates a hedge against market factors.

Long-Bias

Long-bias funds, on the other hand, maintain a different ratio of long to short positions, usually exceeding 40%. A hedge fund with a long/short equity strategy could transition into a long-bias strategy and vice versa, depending on its asset allocation.

Short-Bias

Short-bias funds borrow stock to sell high today with the expectation of buying it back at a lower price in the future and then returning the stock to the lender. These portfolios have a greater potential risk premium than long-bias funds.

Value-Oriented

Value-oriented strategies invest in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or underfollowed by analysts. While positions taken by such funds could be strictly long, they may utilize options, futures, and other derivatives in the process. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market.

Other equity strategies include 130/30, which involves shorting stocks up to 30% of the portfolio value, using the proceeds to take a long position in additional stocks; and directional strategies which open positions either long or short, aiming to correctly predict the movement or direction of a stock.

Long position:

In a long position, the fund buys and holds securities with the expectation that the assets will rise in value.

Short position/short selling:

In a short position, the fund borrows a security and sells at a high price with the expectation of buying it back at a lower price in the future and returning it to the lender.

Event Driven Strategies

Characteristically, event driven strategies hedge funds undertake trades in the securities of specific companies, seeking to exploit pricing inefficiencies that may occur before or after a corporate event. The fund will invest in order to profit when the expected event takes place as predicted. Such events can include earnings calls, bankruptcy, mergers & acquisitions, recapitulations, or spin-offs. Depending on the event, the exact strategy of the fund will differ.

Click on the drop-down to read more about each strategy.

Special Situations

Special situations funds target investments in securities based on ‘special situations’ that most commonly arise out of corporate spin-offs, mergers & acquisitions, bankruptcy, distress, litigation, activism, or any other complex scenario the market may not easily price.

Distressed Debt

Distressed debt strategies buy deeply discounted equity, debt, or trade claims of companies in, or facing, bankruptcy or reorganization. Alternatively, these funds might make investments in distressed securities like bonds, debt, trade claims, common stocks, or preferred stocks to generate profit.

Risk/Merger Arbitrage

Risk/merger arbitrage is a form of arbitrage that involves the simultaneous purchase of shares in one company and the short sale of assets in another. This strategy is typically used in expectation of a pending announcement of a company takeover, where the fund will take a long position in the target firm and a short position in the acquiring firm.

Opportunistic

Opportunistic hedge fund managers vary their strategy as chances arise, profiting from events such as IPOs, sudden price changes caused by interim earnings disappointment, hostile bids, and other event-driven circumstances.

Activist

Activist funds fall under event driven strategies as activism involves purchasing enough of a stake in a public stock to be able to influence profitable corporate change by exerting their shareholder rights.

Relative Value Strategies

Relative value strategies generate profits by capturing price differences between two closely related securities. These strategies therefore tend to use arbitrage.

Relative value strategies bear similar risk to event driven strategies, but on a smaller scale. They face minimal systematic risk, which contrasts with equity strategies. Traditional relative value strategies funds tend to profit during normal market conditions with less volatility and returns, usually making small, frequent profits with occasional large losses.

Explore the drop-down for individual relative value strategies.

Relative Value Arbitrage

Relative value arbitrage involves the simultaneous purchase and sale of two highly correlated assets or securities, seen to be different from their fair values at the time. For example, an investor can buy relatively undervalued off-the-run US Treasury Bills and simultaneously short relatively overvalued on-the-run US Treasury Bills with the same duration.

Statistical Arbitrage

Statistical arbitrage uses mathematical modeling techniques to identify pricing inefficiencies between securities in order to make a profit.

Fixed Income Arbitrage

Fixed income arbitrage follows the same fundamental practices with a focus on bonds, notes, and related securities that provide regular interest payments.

Capital Structure Arbitrage

Capital structure arbitrage seeks to capitalize on price differentials within the capital structure of a single firm; for example taking short positions in company debt and long positions in its equity.

What is Arbitrage?

Arbitrage is the simultaneous buying and selling of an asset in different markets or in derivative forms in order to profit from differences in the price.

Macro and Managed Futures Funds

Macro strategies hedge funds are actively managed funds with the primary aim of profiting from the broad market swings caused by political or economic events. Macro funds tend to participate in all major markets – equities, bonds, currencies, and commodities – using financial instruments to maintain long and short positions based on their research of the global market environment.

Managed futures funds, run by commodity trading advisers (CTAs), invest in a similar manner. These funds tend to use a proprietary trading system to forecast market trends and determine which trades to make. Managed futures funds take long or short positions in futures contracts across metals, grains, equity indices and soft commodities, as well as foreign currency and US Government bond futures. These funds offer the potential for reduced portfolio volatility and the ability to earn profit in any economic environment.

Commodity Trading Advisors (CTAs)

CTAs advise fund managers, providing buy or sell recommendations across commodity, currency, and options markets. They often receive payment through profit generation for their expertise.

Credit Strategies

Credit strategies hedge funds invest solely or primarily in debt instruments, with the aim of profiting from inefficiencies in lending, taking long or short positions in the price of the derivative. Credit funds require significant quantitative analysis as they look to exploit specific risks related to credit instruments, such as default risk, credit spread risk, and illiquidity risk.

Explore the drop-down for more information on credit strategies.

Specialist Credit

Specialist credit funds invest purely on credit investment and employ several credit strategies.

Long/Short Credit

Long/short credit funds take long and short positions in credit instruments such as investment grade, high yield, convertible, or distressed debt to take advantage of opportunities in these asset classes.

Fixed Income Credit

Fixed income credit strategies include investment in long-term government, bank, and corporate bonds, annuities, or preferred stock, which pay a fixed rate of interest to the bondholder at maturity. These funds are often highly leveraged.

Mortgage-Backed

Mortgage-backed strategies focus on trading securities that are secured by a mortgage or a collection of mortgages.

Asset-Backed

Asset-backed strategies use the asset purchased as collateral. For this strategy, the quality of the collateral and not the financial strength of the borrower is prioritized.

Niche Strategies

Niche strategies hedge funds concentrate on specific, small market niches. Explore the drop-down menu to see examples of niche strategies.

Cryptocurrency

This involves investing directly in either cryptocurrencies or crypto-related securities. Typically deploys strategies such as long-only buy and hold; active trading through shorting, futures, and relative value trading; or Initial Coin Offering (ICO) investment.

Insurance-Linked

These strategies are linked to different forms of underlying insurance-related risk, such as life/longevity products, natural catastrophes, or industry loss, with little-to-no correlation to capital markets.

Real Estate

These strategies include investments in this market exclusively, including housing, hotels, and commercial properties.

Alternative Risk Premia

Historically, the alternative risk premia strategy was treated as complementary to the existing core strategy utilized by a hedge fund manager, but in recent years large institutional investors have begun to use the strategy as an investment option in its own right.

Similar to a multi-strategy fund, alternative risk premia is an actively managed strategy that invests long and short across multiple asset classes, such as equities, fixed income, forex, commodities, and interest rates. The strategy aims to generate returns above the risk-free rate – the theoretical rate of return an investment can produce with zero risk – by taking on the risk of a given investment. Often systematic, trading many positions each day means that investors are provided a highly liquid offering, typically with a lower fee than more sophisticated hedge fund strategies.

In this lesson, we discovered the many strategies deployed within hedge fund investments. From equity and event driven strategies to macro and managed futures funds, there are a multitude of different ways investors can allocate to hedge funds.

Next up: Measuring Hedge Fund Returns