Hedge Fund Strategies

An overview of the different ways hedge funds invest capital

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. This 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.

 

Hedge Fund Strategies in NYC

 

What are the Main Hedge Fund Strategies?

The main hedge fund strategies are:

 

Global macro strategies

In this type of strategy, managers make bets based on major global macroeconomic trends such as move 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 -> https://www.bridgewater.com/.

 

Directional hedge fund strategies

In this approach, managers bet on the directions 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 be applied to long or short equity hedge funds and emerging markets funds.

 

Event-driven hedge fund strategies

Adapted to situations wherein the underlying opportunity and risk are associated with an event. These managers find investment opportunities in corporate transactions, such as acquisitions, consolidation, recapitalization, liquidation, and bankruptcy. These transactional events fit into distressed securities, risk arbitrage, and special situations.

 

Relative value arbitrage strategies

These hedge fund strategies take advantage of relative price discrepancies in two securities, which the manager expects to diverge or converge over time. Other sub-strategies include – fixed income arbitrage, equity market neutral, convertible arbitrage, and volatility arbitrage, among others.

 

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.  If the overall market goes up or down, they will be okay as long as Coke performs better than Pepsi on a relative basis.

 

Capital structure strategies

Some hedge funds take advantage of mispricing of securities up and down the capital structure of one single company.  For example, they belive the debt is over valued, so they short the debt and go long the equity, thus having 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 accredited or qualified 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 multiply returns.
  • The fund carries a management and performance fee. It usually pays an annual manager’s fee of one percent of the assets and a performance fee of 20 percent cut 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 quarterly or semi-annually.
  • This fund uses different investment strategies that must be disclosed upfront to the investors.

 

 

What are the General Types of Hedge Funds?

Open-ended hedge funds

Shares are continuously issued to investors and allow periodic withdrawals of the net asset value for each share.

Closed-ended hedge funds

Issue only a limited number of shares through an initial public offering and do not issue new shares, even if an investor demands increases.

Shares of listed hedge funds

These are traded on stock exchanges and non-accredited investors may purchase them.

 

What are the Pros and Cons of Investing in Hedge Funds?

Investing in hedge funds can bring remarkable benefits to an investor; however, there is always risk involved in highly rewarding transactions.

Pros
  • 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 competence to precisely customize investment strategies.
  • Investors can access the services of skilled investment managers.
Cons
  • 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.

 

Additional resources

Thank you for reading this article on hedge funds.  To keep learning and developing your career, CFI is happy to offer these additional resources for free:

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