What is a Hedge Fund?
In this article, we will explore the main hedge fund strategies. But first, what is a hedge fund?
A hedge fund is an investment fund created by accredited individuals and institutional investors for the purpose of maximizing returns and reducing or eliminating risk, regardless of market climb or decline. It is basically a private investment partnership between a fund manager and the investors of the fund, often structured as a limited partnership or limited liability company. The partnership operates with little to no regulation from the Securities and Exchange Commission (SEC).
What are the Main Hedge Fund Strategies?
The main hedge fund strategies are as follows:
1. Global macro strategies
In the global macro strategy, managers make bets based on major global macroeconomic trends such as moves in interest rates, currencies, demographic shifts, and economic cycles. Fund managers use discretionary and systematic approaches in major financial and non-financial markets by trading currencies, futures, options contracts, and traditional equities and bonds. Bridgewater is the most famous example of a global macro fund.
2. Directional hedge fund strategies
In the directional approach, managers bet on the directional moves of the market (long or short) as they expect a trend to continue or reverse for a period of time. A manager analyzes market movements, trends, or inconsistencies, which can then be applied to investments in vehicles such as long or short equity hedge funds and emerging markets funds.
3. Event-driven hedge fund strategies
Event-driven strategies are used in situations wherein the underlying opportunity and risk are associated with an event. Fund managers find investment opportunities in corporate transactions such as acquisitions, consolidations, recapitalization, liquidations, and bankruptcy. These transactional events form the basis for investments in distressed securities, risk arbitrage, and special situations.
4. Relative value arbitrage strategies
Relative value arbitrage hedge fund strategies take advantage of relative price discrepancies between different securities whose prices the manager expects to diverge or converge over time. Sub-strategies in the category include fixed income arbitrage, equity market neutral positions, convertible arbitrage, and volatility arbitrage, among others.
5. Long/short strategies
In long/short hedge fund strategies, managers make what are known as “pair trades” to bet on two securities in the same industry. For example, if they expect Coke to perform better than Pepsi, they would go long Coke and short Pepsi. Regardless of overall market trends, they will be okay as long as Coke performs better than Pepsi on a relative basis.
6. Capital structure strategies
Some hedge funds take advantage of mispricing of securities up and down the capital structure of one single company. For example, if they believe the debt is overvalued, then they short the debt and go long the equity, thus creating a hedge and betting on the eventual spread correction between the securities.
What are the Distinct Features of a Hedge Fund?
The main features of a hedge fund are as follows:
- The fund is open to only qualified or accredited investors and cannot be offered or sold to the general public. Certain net worth requirements need to be met by potential investors (net worth of more than $1M excluding primary residence).
- The fund can exist as extensive investments in various sectors, such as land, stocks, derivatives, currencies, and commodities.
- It often uses borrowed money to create leverage and multiply returns.
- The fund comes with management and performance fees. It usually pays an annual manager’s fee of 1% of the amount of invested assets and a performance fee of 20% on any gains.
- Investors are required to maintain their money in the fund for a locked-in period of at least one year. Withdrawals of funds may only happen at specific times, such as quarterly or semi-annually.
- The fund uses different investment strategies that must be disclosed upfront to the investors.
What are the General Types of Hedge Funds?
1. Open-ended hedge funds
Shares are continuously issued to investors and allow periodic withdrawals of the net asset value for each share.
2. Closed-end hedge funds
They issue only a limited number of shares through an initial offering and do not issue new shares even if investor demand increases.
3. Shares of listed hedge funds
They are traded on stock exchanges and non-accredited investors may purchase the shares.
What are the Pros and Cons of Investing in Hedge Funds?
Investing in hedge funds can bring very high returns to an investor; however, there is always risk involved in potential high-reward investments.
- The use of various investment strategies provides the ability to generate positive returns despite favorable or unfavorable market conditions.
- A balanced portfolio hedge fund can decrease overall risk and volatility, with multiple returns on investment.
- Provides investors the ability to precisely customize investment strategies.
- Investors can access the services of skilled investment managers.
- Exposes the fund to huge potential losses if the wrong strategy is taken.
- Investors are usually required to lock in the money for a period of years.
- Use of borrowed money or leverage can turn a minimal loss into a major loss.
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