June 23, 2021

Different Types of Hedge Fund Strategies Explained

HUDSONPOINT Team
Written by: HUDSONPOINT Team
Alternative Investment, Hedge Funds, Stock Market

hedge fund strategies, hedge funds, hudsonpoint capital, hedge fund, alternative investment

In this article, we discuss different types of hedge fund strategies for investors.

Hedge funds  are complex investment units that use various tactics to earn active returns for their investments. Many funds have an open mandate, meaning they can use whatever tools at their disposal to generate market-beating returns. Oftentimes this leads to the use of excessive leverage, complicated derivatives, short-selling equities, and in-depth corporate activity arbitrage (to name a few).

While hedge funds may employ a variety of strategies, they usually stick to just a few or, in many cases, just one. It’s hard enough to execute one strategy effectively, let alone multiple. Successful funds develop a core strategy that works for them, using the unique resources and talent they have available, opportunistically stepping outside of it when attractive options present themselves.

When it comes to investing in hedge funds, you need to understand how each fund, as a prospective opportunity, aims to generate a return as well as the risks they take to do so. Specific strategies may appeal more to you than others, and some may not fit within your investment risk or ethical framework at all. Let’s take a deep dive into the different types of hedge fund strategies available.

 

Long/Short Equity Strategies

Perhaps the most common hedge fund strategy of them all is the long/short equity strategy. It’s also one of the simplest to understand. The very first hedge fund initiated this strategy on the premise that when there are both expected winners and losers, there is an opportunity to profit off both. That is, take long positions in expected winners and bet on short positions against the expected losers. The combined portfolio naturally reduces market risk and instead captures the stock-specific expectations formulated by the manager.

Long/short hedge funds may use a range of research ideologies and tools, such as fundamental and quantitative techniques. History shows us that long/short strategies have a bias for long exposure, probabilistically based on the nature of the general market to rise over time. Since this type of strategy utilizes publicly traded equity and derivatives to earn a return, there are relatively low barriers to liquidating positions, meaning these funds can be more flexible with their investors when it comes to funding additions and withdrawals.

 

Market Neutral Strategies

Market-neutral funds take the long/short strategy and apply the short component more strictly. Market-neutral essentially means that the hedge fund targets zero net-market exposure—long positions are equally offset by short positions. The entire return of the fund is driven by the quality of the stocks selected by the manager, irrespective of the movement of the market.

This strategy is a relatively low-risk approach, as only extreme divergences in stock pairings would facilitate dramatic capital loss. However, it’s also expected to generate lower returns than other more aggressive strategies. The benchmark is usually the long-term bond rate; since the risk is minimized, outperformance is valuable to a risk-averse investor seeking additional return.

Market-neutral strategies have fallen in popularity as interest rates have approached zero. As stocks are held short, cash collateral can be held against the loaned shares – generating interest for the borrower (the hedge fund), which means that even if markets are flat, the fund could still generate approximately the overnight cash rate. Since that is near-zero, this benefit has evaporated.

 

Arbitrage Strategies

Arbitrage is the practice of taking advantage of different prices (for the same or similar asset) across different markets. Hedge funds that employ a range of arbitrage strategies are seeking to exploit market inefficiencies by purchasing and selling particular investments at the same time.

Data and signaling can be used to identify slight mispricings across the globe and take advantage of the differences. Of course, since the opportunities are relatively small, leverage is often used to generate substantially larger returns. There are four common types of arbitrage:

 
Merger arbitrage
Mergers and acquisitions (M&A) present opportunities for swift investors to take positions in two merging companies that look to profit off any pricing inefficiencies that may occur during and after the merger goes through (or doesn’t). The market may inappropriately price the acquiree (not reflecting the offer they’ve been given) or misread the impact on the acquirer. Either way, astute hedge funds use their expertise to identify opportunities to make money.

 
Convertible arbitrage
Convertible arbitrage is a complex strategy designed to take advantage of pricing mismatches between a company’s convertible securities and its underlying stock. The timing of the trades matters significantly, and small inefficiencies must often be exploited using high leverage to
make it worthwhile.

 
Capital structure arbitrage
This is a strategy that takes advantage of pricing differences between different securities of the same company. Overvalued securities are sold, while undervalued securities are bought. The goal is to profit from pricing inefficiencies in a company’s capital structure.

It’s a complicated process that may use quantitative models to assess, for example, differing news impacts on the bond and equity components of a firm. While bond payments are fixed, dividends and stock prices are far more variable, soliciting chances to profit from mismatches in outcomes.

 
Fixed-income arbitrage
Interest rate securities, such as bonds and swaps, offer minor pricing inconsistencies from time to time. Fixed-income arbitrage usually involves taking a long and short position in either a swap and a bond to make a small profit. However, the downside risk is significant if both positions go wrong – bonds may not be repaid, and interest payments may not occur. The strategy is often used to generate small incremental returns beyond the core hedge fund’s goals.

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Event-driven Strategies

The world is awash with meaningful news and events every day. Some hedge funds make specific plays relating to real-world or corporate events, such as mergers, restructuring, buybacks, share issuances, or even bankruptcies.

Event-driven strategies require specific expertise and knowledge to develop a reading on the likely outcome and flow-on effects of corporate events. Arbitrage strategies are also usually the result of a relevant corporate action that creates mispricings to be taken advantage of.

Events can take a long time to play out, so investors in event-driven strategies must be patient and back the manager’s skill to identify suitable risks and opportunities for the fund to make a play on and which to avoid.

 

Global Macro Strategies

Macro strategies look primarily at the big global picture and large-scale events that affect countries and international financial markets. Global macro hedge funds use economic analysis and tools to predict the economic fate of a country’s economy both on its own and in relation to others.

These hedge funds can make plays on a country’s fortunes in many ways by trading debt, real estate, commodities, equities, and often currencies. Currencies and interest rate instruments are heavily linked to the underlying economic health and direction of individual economies as well as their interactions with others. Maco-based hedge funds will typically avoid playing in individual equities unless there is a solid link to the macroeconomic thesis.

 

Quantitative Strategies

Quantitative hedge funds, often linked to the term ‘Quants,’ use mathematical modeling and rich data to form predictions on the movements of tradable products and derivatives.

Typically, quantitative hedge funds will employ highly educated analysts, many with PhDs, to develop complex models that identify patterns in data. The fund then takes advantage of small pricing discrepancies over and over, a process that is often automated and computer-driven.

Many of the most well-known and successful hedge funds rely on a quantitative strategy, such as the famous Medallion Fund run by Renaissance Technologies and billionaire mathematician Jim Simons. Of course, successful quantitative funds do not reveal their inner workings and are relatively secretive so that others can’t copy their mathematical advantages.

 

Short-only Strategies

Short-only hedge funds are certainly not for the faint-hearted. Opposed to long-only funds or individual investors, short-only funds directly bet against companies in order to profit. Often this involves researching equities that they believe to be heavily overvalued.

Their research may be very hands-on, digging deep into financial statements to uncover signs of accounting fraud or investigating physical stores and supplier networks on the ground to fund any irregularities.

While it sounds like an exciting place to be, it is also highly challenging. Short-only fund managers have the general rise of the market over time to compete with. While they often perform well during general market sell-offs, their ability to outperform lies in the skill of the manager to uncover overvalued opportunities in the market consistently.

 

Credit Fund Strategies

Credit-based hedge funds make trades in debt instruments based primarily on perceived lending inefficiencies in the market. Credit hedge funds opportunistically take advantage of cyclical patterns and changes in interest rate markets.

One common target of credit funds is distressed debt—corporate bonds, bank debt, and sometimes preferred stock in companies that are at risk of bankruptcy. The legal complexity of these situations is the advantage experienced, and resourceful hedge funds have over the average investor, able to identify solid risk-adjusted investment opportunities in the debt market. Credit-based hedge funds are less correlated to the market and often perform well when other companies are at greater risk of failing.

 

Multi-Strategies

Many hedge funds want to retain flexibility and are open about that with their investors. Running multiple strategies within the fund allows managers to target active returns whenever opportunities present themselves, not just when the stars are aligned to a particular mandate.

One famous hedge fund that employs a multi-strategy approach is Millennium Management. The firm employs over 265 portfolio management teams (almost 3,000 individuals) under a ‘platform model’ of investing. Each portfolio manager is allocated money to deploy using their specific trading strategy.

Of course, every fund can mix and match its strategy depending on what opportunities present themselves and the mandate of their investors. Some funds will strictly execute only their disclosed strategy, whereas others will be far more adaptive. Whether or not a particular strategy is successful or not comes down to the fund manager’s skill, general market movements, and in the short term, perhaps an element of luck.

 

Investing in Hedge Funds

Accessing an investment in a hedge fund as a retail investor can be complex and onerous, particularly if you do not meet the minimum capital requirements. Identifying the right strategy for your portfolio, or part of it, using hedge funds is best done with the backing of experienced providers that understand hedge funds with expert depth.

HUDSONPOINT Capital provides retail investors with the investment and advice platform they need to access a broad range of investment opportunities, including the best hedge funds using different types of effective strategies. By pooling investor’s funds, HUDSONPOINT can help access unique hedge funds strategies for qualified investors as part of their more comprehensive financial strategy.

 

If you’re interested in adding Hedge Funds to your portfolio, please schedule a call to learn more about what we have available right now.

 

Please note that any investment involves risk including loss of principal. Some risks of investing directly or indirectly in real estate include declining real estate values, changing economic conditions and increasing interest rates.

There can be no assurance that any hedge fund will achieve its investment objectives. There exists a possibility that an investor could suffer a substantial or total loss as a result of an investment. Prospective investors should be aware of the substantial risks of investing in any hedge fund and must, either individually or together with his advisors, have the financial sophistication and expertise to evaluate the merits and risks of investing.

This is for informational and educational purposes only and should not be construed as investment advice or an offer or solicitation of any products or services. Opinions are subject to change with market conditions. The views and strategies may not be suitable for all investors and are not intended to be relied on for legal or tax advice.

Securities offered through National Securities Corporation Member FINRA/SIPC

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