The 4 Most Common Hedge Fund Investment Strategies

Unless you’re a seasoned institutional investor with a wealth of experience, knowing what makes hedge funds tick—and, more importantly, what makes them successful—is easier said than done.

Especially since many hedge funds may end up underperforming the market in the long run.

The truth is that while most new hedge funds start strong, only 62% of hedge funds remain in business five years after beginning operations, while roughly one in three hedge funds wind down operations every year.

That being said, hedge funds can possibly provide a source of uncorrelated returns if you know which types of hedge fund strategies best complement your portfolio.

It’s important to remember why they’re called “hedge” funds in the first place—as an investment vehicle, hedge funds were never meant to be get-rich-quick schemes. They were meant to balance out your portfolio and give you a hedge against bearish markets and an edge in bullish markets.

Here are some of the most common hedge fund strategies you might encounter when exploring your options as an investor.

 

 

1. Long/Short Equity

One of the classic hedge fund strategies, long/short equity was utilized by the first-ever hedge fund in 1949, and remains popular to this day.

The rationale behind long/short equity involves betting on both winners and losers in the market, taking long positions on winners to finance short positions on losers. This allows for possibly greater stock-specific gains while also minimizing market volatility risk.

In short, long/short investors make long and short investments on competing companies within one industry. The combined performance of those companies determines the investor’s overall profit and also ensures that they are not totally correlated with the overall market.

For example, a long/short equity trader could purchase Netflix stock and short an equal value in Disney stock. Assuming Netflix outperforms Disney+ and/or Hulu, the investor is likely to profit. If Disney’s streaming services outperform Netflix, the investor may also profit.

The key to long/short investing is that no matter what the market is doing, there’s a hedge that limits losses and offers the potential for gains.

Of course, long/short strategies are mostly long since the market tends to be more bullish than bearish over time, but short positions provide valuable hedges against bear markets.

As with all investments the Long/Short strategy comes with some risk. The Four main risks are Market Risk, Idiosyncratic Risk, Short-Sale Risk and Leverage Risk.

 

 

2. Market Neutral

Speaking of long/short equity strategies, which often have a net long exposure to the market, market-neutral strategies target zero-market exposure, meaning that both long and short investments have equal market value.

This means that market-neutral hedge fund managers base their returns off of their specific stock selections, which incurs a lower risk than long/short equity, but also offers a lower potential for profit.

An example of a market-neutral strategy would be going long in a basket of stocks that are likely to outperform the overall market, while simultaneously shorting a basket of stocks expected to underperform the market.

Regardless of actual market performance, the overall portfolio remains market neutral, and will balance out gains with losses and vice versa no matter what happens. Ideally.

Of course, no one can predict the future, so whether a strategy is truly “market neutral” is impossible to say until all the cards are on the table. The biggest risk to a market neutral strategy is that it isn’t actually market neutral, which could lead to unforeseen gains or losses.

 

 

 

 

3. Merger Arbitrage

A merger arbitrage strategy is exactly what it sounds like—betting on the short-term gains or losses from a recently announced mergers or takeovers.

Stock in the merging or target companies is bought and sold-short by a hedge fund based on certain, pre-agreed conditions, including a favorable vote from company shareholders and regulatory approval.

Say, for example, public company X has shares priced at $15. Suddenly, news comes out that public company Y wants to buy X for $25 per share. Company X’s stock will jump in value, and eventually settle on a price between $15–$25 per share, until the merger between the companies is finalized.

If the first company’s stock is trading at around $23 per share, a risk arbitrageur would purchase shares at $24, pay a commission to maintain the shares, and sell them for $25 a share once the deal is closed.

If it sounds like easy money, it isn’t. The risk inherent to this strategy is that sometimes mergers and takeovers (think Elon Musk’s soap opera with Twitter) may not end up happening. This uncertainty makes the merger arbitrage strategy an inherent gamble, but one with fairly good odds of success.

 

 

4. Global Macro

As the name suggests, global macro investment strategies are traditional “big picture” strategies that take into consideration how international politics and economics may impact different countries, companies, commodities, and currencies.

The biggest advantage of a global macro strategy is that you can trade almost anything, although most managers prefer highly liquid assets with a lot of volume, like stocks and currencies.

The biggest disadvantage is that whoever is helming the fund has to understand so much more than just how to buy and sell stocks and options. Global macro investors tend to be traditionally educated economists, investors, and financiers who have a deep understanding of macroeconomics that few people will ever achieve.

Unfortunately, global macro strategies are some of the most difficult to understand and can be very risky for the same reason. Some bets never pay off, others may lose a lot of money, and others may lead to fortunes. When it does pay off, however, the potential returns could be large.

The most famous global macro investor of all time may very well be George Soros, whose powers of prediction “broke the pound” back in 1992. His short position, over $10 billion in British pounds, led to a $1.1 billion return, as the Bank of England was hesitant to raise interest rates or float its currency to match other European exchange rates.

 

 

Hedge your bets

Interested in learning more about different hedge fund strategies, how to invest in hedge funds, and how they can help diversify your portfolio? Schedule a call today to see how Hedge Funds can fit into investment portfolio.

At HUDSONPOINT capital, our team of dedicated investment executives can provide you with the latest up-to-date information on alternative investment strategies, including successful hedge fund planning, and how you can make them work within your portfolio.

 

 

 

The opinions expressed are those of HUDSONPOINT capital and not those of B. Riley Financial and National Securities Corporation.

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.

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.

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