Hedge Fund Strategies

Most of the time, hedge funds are lumped together under one umbrella.  While the aims of fund managers are basically the same, the methods can be very different.  By methods, I mean investment strategies.  There are four main categories of strategies:  market directional, event driven, arbitrage and opportunistic.

Market directional strategies are affected by the securities markets.  When the term hedge fund is mentioned, the investing public immediately thinks of two of them - equity long/short and short.  The former allows the portfolio manager to have both long and short positions within the fund while the latter has short positions.  The other two are less popular - activist and emerging markets.  The activist hedge fund tries to improve the management of its positions and profit from the subsequent rise in stock price.  The emerging market fund invests in its namesake.

Corporate restructuring (aka risk arbitrage) funds invest in companies undergoing a current or possible transaction.  The most well known strategy is merger arbitrage which is based on a merger between two companies and whether or not it will be completed.  The distressed securities strategy invests in companies that are being re-organized or are in bankruptcy proceedings.  Event driven funds invest in companies that are going through mergers, bankruptcy, spinoffs, re-organization, special dividends or stock buybacks.  Regulation D invest in securities issued through private placements such as through rule 144A.

Arbitrage funds identify two similar securities with different prices will converge to the same price.  The main strategies are fixed income arbitrage, convertible bond arbitrage, equity market neutral and relative value arbitrage. The first two capture price discrepancies between buying a security (bond or convertible) and hedging that position by shorting a similar security.  Equity market neutral combine long and short positions in a portfolio to eliminate market risk.  Relative value arbitrage strategies find a relationship between the prices of two securities.  When there is a discrepancy to the historical pricing, the funds seeks to take advantage of it and profit when the relationship returns to the norm.

Opportunistic strategies are global macro and fund of funds.  Global macros managers take a top-down investment approach.  They look at macroeconomic factors and invest accordingly.  Funds of funds invest in other hedge funds.  Depending on market conditions, they are able to re-allocate capital to generate superior returns.

We will take a closer look at these strategies in later entries.  There are other strategies that are not as  common and we may review them too.