Hedge Fund Strategies

An overview of the different ways hedge funds invest money.

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.

What are the Distinct Features of a Hedge Fund?

  • 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 to 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 Main Strategies of a Hedge Fund?

Global macro strategies – fund managers use discretionary and systematic approaches in major financial and non-financial markets by trading currencies, futures, option contracts, and traditional equities and bonds.

Directional strategies – use of market movements, trends, or inconsistencies.  Applied to long or short equity hedge funds and emerging markets funds.

Event-driven strategies – adapted in situations wherein the underlying opportunity and risk are associated with an event. These 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 take advantage of relative price discrepancies in one or two securities. Other sub-strategies include – fixed income arbitrage, equity market neutral, convertible arbitrage, and volatility arbitrage, among others.

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.