hedge fund strategies

8 Hedge Fund Strategies That Investors Should Know

There are numerous hedge fund strategies and sub-strategies that exist within the hedge fund universe. While it is difficult to define every single category, there are eight major approaches that are commonly employed by hedge funds. It is important for investors to understand these basic concepts before they get into hedge fund investing.

1. Equity Hedge – This hedge fund strategy is often referred to as long/short. It is the most commonly used strategy in the hedge fund industry. The hedge fund manager exploits differences in stock prices by purchasing stocks that are perceived to be undervalued (long), and selling the ones that are deemed to be overvalued (short) at a certain point in time. In the process, the manager uses both quantitative and qualitative analyses to identify the fair price. Fundamental analysis, for example, is commonly used to assess the intrinsic value of an investment. While the long/short strategy doesn’t explicitly guarantee protection from the market, an equity market neutral strategy, which uses the same strategy as long/short, minimizes broad market exposure. Market neutral funds do so by minimizing beta, which is a measure of the volatility of a portfolio in relation to the overall market.

 

2. Global Macro – This strategy relates to trading activities based on the manager’s view of economic drivers and political changes that can have an impact on the markets. Global macro managers can employ a variety of techniques and asset classes to capitalize on changing market environments. However, even though the global macro strategy can generate substantial returns, the risk involved are high as there are many different factors, such as foreign exchange rates, interest rates, or other macro-related elements that can affect performance.

 

3. Event-Driven – This is a hedge fund strategy whereby a hedge fund will be involved in major corporate activities that can have a substantial impact on the company’s value. These activities include IPO, merger, acquisition, restructuring, financial distress, tender offers, shareholder buybacks, debt exchange, or other capital structure changes. Naturally, company specific developments, both public and private, are the major drivers of performance, instead of market-related factors.

 

4. Relative Value Arbitrage – This hedge fund strategy attempts to take advantage of price discrepancies between financial instruments. For example, when there is a momentary discrepancy in the pricing between two or more related securities, the strategy attempts to benefit from purchasing the security that is expected to appreciate and selling the security that is expected to depreciate. The transactions occur simultaneously as the manager is acting based on the assumption that the prices of these securities will normalize. As relative value arbitrage is capitalizing on the relation between two or more securities in terms of price, a quick directional movement in the market can be dangerous. Therefore, managers are not only paying attention to individual securities, but also broad market sentiment. Only sophisticated managers are capable of taking this risk.

 

5. Credit – This strategy primarily invests in fixed income securities, most typically in sovereign, municipal, corporate, and/or distressed debt. Historically, fixed income securities played an important role in financial and economic development. Also, as the 2007-8 crisis showed, fixed income markets are closely interrelated with the global economy and our everyday lives. Normally, credit hedge fund managers trade fixed income securities for a ‘secured’ return, but more sophisticated managers with significant assets can deploy a riskier strategy, such as arbitrage, to generate higher profits.

 

6. Quantitative – Quantitative funds trade positions by using sophisticated computer models to identify investment opportunities. Many new technologies have emerged in recent years, such as high-frequency trading. In fact, the root of this strategy goes back to when Commodities Corporation, one of the earliest quant funds, pioneered the field. Since then, quant strategies have become widely adopted in the financial industry. Many mathematicians and “rocket scientists” ventured into Wall Street to further develop this emerging field. Most recently, Ray Dalio, founder and manager of one of the largest hedge funds in the world, Bridgewater Associates, mentioned that the firm uses artificial intelligence to find opportunities.

 

7. Multi-Strategy – Multi-strategy funds use several different processes within the same pool of assets. The biggest benefit to this approach is that the fund becomes broadly diversified. Diversification helps smooth performance and reduce the volatility of a portfolio. On the other hand, the performance may become diluted and yield unattractive returns. Also, having investments in multiple assets in different locations can obscure the exposure of the fund. Often times, large institutions that can allocate enough resources into different areas play a big role in this field.

 

8. Managed Futures Trading (CTA) – Also known as commodity trading advisors, managed futures traders can invest in up to 150 global futures markets[1]. Futures are a financial contract obligating the buyer to purchase an asset at a predetermined price at a specific future date. CTAs can vary in terms of the strategy that they deploy, but the commonality among them is that they trade complex derivatives by using proprietary systems. One of the benefits of this approach is that CTAs can have zero to negative correlation with stocks or bonds. Because of the risk involved in this strategy, however, they are heavily regulated by the Commodity Future Trading Commission (CFTC) and National Futures Association (NFA).

[1] Futures security is a type of financial contract obligating the buyer to purchase an asset at a predetermined price. Futures and derivative products are complex securities.

 

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