A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously many hedge against downturns in the markets especially important today with volatility and anticipation of corrections in stock markets. The primary aim of most, but not all, hedge funds, is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.
There are approximately 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return. A macro hedge fund, for example, invests in stock and bond markets and other investment opportunities, such as currencies, in hopes of profiting on significant shifts in such things as global interest rates and countries’ economic policies. A macro hedge fund is more volatile but can potentially deploy greater assets than a distressed-securities hedge fund that buys the equity or debt of companies about to enter or exit financial distress. An equity hedge fund may be global, country specific or industry specific, hedging against downturns in equity markets by shorting what they determine to be overvalued stocks or stock indexes. A relative value hedge fund takes advantage of price or spread inefficiencies. Knowing and understanding the characteristics of the many different hedge fund strategies is essential to capitalizing on their variety of investment opportunities.
It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies, which are not correlated to equity markets, are able to deliver consistent returns with extremely low risk of loss, while others may be as, or more, volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.
A wide range of hedging strategies are available to hedge funds. For example:
The predictability of future results shows a strong correlation with the volatility of each strategy. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility.
Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro cap stocks which are expected to experience rapid growth. Includes sector specialist funds such as technology, banking, or biotechnology. Hedges by shorting equities where earnings disappointment is expected or by shorting stock indexes. Tends to be "long-biased but somewhat correlated to stock market direction. Expected Volatility: High
Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market's lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities (This selling pressure creates the deep discount). Results generally are not dependent on the direction of the markets. Expected Volatility: Low - Moderate
Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and greater growth potential, though their fortunes are usually dependent on the more mature economies. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available or is difficult to implement. Will mostly be correlated to stock market direction. Expected Volatility: Very High
Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Returns, risk, and volatility can be controlled by the mix of underlying strategies and funds. Capital preservation is generally an important consideration. Volatility depends on the mix and ratio of strategies employed. Correlation with stock markets depends on the objectives of the fund and underlying investment strategies. Expected Volatility: Low - Moderate - High
Income: Invests with primary focus on yield or current income rather than solely on capital gains. May utilize leverage to buy bonds and sometimes fixed income derivatives in order to profit from principal appreciation and interest income. Performance uncorrelated to the direction of stock markets. Expected Volatility: Low
Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets equities, bonds, currencies and commodities though not always at the same time. Uses leverage and derivatives to accentuate the impact of market moves. Utilizes hedging, but the leveraged directional investments tend to make the largest impact on performance. Performance uncorrelated to the direction of stock or bond markets. Expected Volatility: Very High
Market Neutral - Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers’ equity. May also use futures to hedge out interest rate risk. Focuses on obtaining returns with low or no correlation to both the equity and bond markets. These relative value strategies include fixed income arbitrage, mortgage backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low
Market Neutral - Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced, but effective stock analysis and stock picking is essential to obtaining meaningful results. Leverage may be used to enhance returns. Usually low or no correlation to the market. Sometimes uses market index futures to hedge out systematic (market) risk. Expected performance returns are moderate. Relative benchmark index usually T-bills. Expected Volatility: Low
Market Timing: Allocates assets among different asset classes depending on the manager's view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. Expected Volatility: High
Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. May utilize several of these investing styles at a given time and is not restricted to any particular investment approach or asset class. Expected Volatility: Variable
Multi Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable
Short Selling: Sells securities short in anticipation of being able to buy them back at a future date at a lower price, due to the manager's assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High
Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread between the current market price and the ultimate purchase price of the company. May also utilize derivatives to leverage returns and to hedge out interest rate and/or market risk. Results generally not correlated to or dependent on direction of stock markets. Expected Volatility: Moderate
Value: Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favor or underfollowed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market. As a result, performance may lag the market for years on end, before performance kicks in. Expected Volatility: Low - Moderate
It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.
Key Characteristics of Hedge Funds