Hedge funds pursue different ways to make money from the markets
There are different hedge fund strategies. Often, a single fund specializes in one of these strategies. We list and discuss them here in more detail.
List of different hedge fund strategies
There are multiple hedge fund strategies. These include:
Long-short hedge fund strategies. Buying stocks (or other securities) long means making an actual purchase of shares in expectations these will rise in value. Therefore, stocks which the hedge fund manager deems to be underpriced will be bought. One the other hand, there are stocks which the manager considers to be overvalued and so will bet on their fall. This is called selling short.
As mentioned before, selling short means borrowing shares which the investor (including hedge fund investors) doesn’t hold, selling them in the market with the expectations that the price of these shares will decline, and then buying them back at a lower price. The short seller only needs to return the borrowed quantity of shares, no matter what’s their current price. So, if shares sold short can be later repurchased at a lower price, an investment gain occurs.
For example, if you sell short 100 shares at $10 for a total of $1,000, this is the amount that will go into short seller’s account. Later, if the shares can be repurchased at $8, the cost to return the borrowed shares will be $800, creating a $200 gain (less transaction costs).
Selling short is a risky business. While the shares can only fall down to zero (in the example above it would be a $10 fall, and that would be the maximum gain), they can as well rise indefinitely to a price of, let’s say, $100. Nevertheless, short selling is a common practice and given right risk management, it can contribute to profits. As with many other strategies, the long/short strategy can be applied to other financial instruments.
Market neutral strategy. This is another hedge fund investing style and it involves dividing the investments between long and short holdings, thus having a zero net exposure to the market. Of course, the hedge fund manager hopes that the long holdings will rise and short ones will fall, but if the market makes sudden moves (i.e. falls rapidly), the short and long holdings would more or less cancel each other, mitigating systemic risk.
A related market neutral strategy seeks to minimize beta. A Beta is a measure of market volatility. A beta of 1 means a specific security (such as a stock) is as volatile as the market. Beta above 1 means the holding is more volatile than the market, and a beta below 1 means it is less volatile. By applying market neutral strategy, the hedge fund manager will seek to keep the beta of positions as close to zero as possible.
Global macro. This hedge fund strategy is broad-based when it comes to asset classes. A fund manager may invest in stocks, bonds, commodities, and a variety of financial derivatives such as futures, forwards, and options. (Basically, these derivative instruments allow for purchase of specific assets at a future date for a set price.) Moreover, leverage (borrowing funds to increase the buying power) is widely used with this strategy.
Arbitrage. Many hedge funds are known for arbitrage. These investment styles seek to take advantage of discrepancies in pricing of various securities whether these are equities, bonds, commodities, derivatives, or foreign exchange. In effect, mispriced securities are quickly brought up to their intrinsic value by arbitrage. Nowadays, when securities become mispriced in relation to each other, arbitrage takes place almost instantaneously with the use of powerful algorithms and computer systems, while using massive amounts of money and leverage. This effectively precludes an average retail investor from pursuing most arbitrage opportunities.
There are different arbitrage strategies. One is called relative arbitrage. It involves buying one security and selling the other. When the fund manager determines that one security is overpriced in relation to the other, the overpriced security is sold short, while the underpriced one is bought long. When other investors do that as well, this quickly brings the values of both to their equilibrium value.
Why these opportunities happen in the first place? It is due to the supply and demand conditions that temporarily bring the relationships among securities out of sync. One example is the relationship between a stock and the option (the right to purchase a stock at a future date for a set price). According to option pricing models, the price of a stock option is based on the value of the underlying stock and other factors (such as time left before the option expires). If the value deviates, arbitrage opportunities come to life.
Another example is the price of bonds. Bond prices also depend on many factors including interest rates. If interest rates change, that should be reflected in the prices of bonds. Sometimes the market will temporarily misprice bonds, resulting in arbitrageurs immediately taking advantage of it by buying long underpriced bonds and selling short overpriced ones until a proper valuation is achieved. Rapidly arriving at the right price is considered to be a benefit that arbitrage plays in correct pricing of securities.
A second form of arbitrage is convertible arbitrage, which is closely related to relative value arbitrage. Usually it involves shares of a company and its convertible bonds (these are bonds which can be converted into stocks at a set ratio). For example, if a $1000 bond can be converted into 100 shares of a stock, this implies that the market value of a stock should $10. (There are other factors but let’s not complicate the idea of arbitrage too much at this phase.)
If the price of a stock is different, then convertible arbitrage opportunities exist. In that case, either the price of a convertible bond needs to change or the stock price needs to do so. Once again, when the supply and demand conditions disrupt the equilibrium (even by very little), arbitrage will take place almost instantaneously to correct the mispricing. For arbitrage firms, even little discrepancies multiplied by huge leverage can produce handsome profits.
Distressed securities. Hedge funds specializing in this area invest in companies that are in deep trouble. Investments made can include stocks and bonds trading well below their previous levels. The hope here is that these companies can recover, be reorganized, or their liquidation proceeds will exceed investments made. Since the process of recovery can be quite long (sometimes lasting years), the investors in these hedge funds may have their money locked in for many years.
Special situations or event-driven funds. With these funds, the focus is on specific events such as mergers, leveraged buy-outs, and corporate events including hostile takeovers (where another company, or a group of investors, is seeking to take control of a company against the will of its management). One of the strategies pursued by these hedge funds involves selling shares of the acquirer and buying shares of the company being purchased.
If there’s a tender offer for, let’s say, $9, for a stock that’s been trading at $7, the market price of this company will approach $9, but because of the risk that the tender collapses, the actual market price may be $8.90. For those willing to take this risk, there is an arbitrage gain of $0.10 (minus transaction costs) waiting.
Opportunistic funds. This is another kind of funds pursuing event-driven strategies. Here, the advantage is taken on events such as Initial Public Offerings (IPOs), earning disappointments, and market shocks.
Market timing funds. In these hedge funds, the management seeks to find the best time to enter and exit the markets. The investment and strategy array changes over time as market conditions change. These funds seek to quickly adapt to the ever-changing nature of the financial markets.
Emerging markets funds. Just like with many other funds- such as open-end, closed-end, or exchange-traded funds- there are hedge funds which focus on emerging markets securities.
Income funds. The focus of these is to generate interest and dividend income rather than capital gains. In many ways, these are similar to income mutual funds.
Value funds. These funds pursue bottom-fishing, hoping to find gems among hammered stocks and other securities, believing that they trade well below their intrinsic values. If the picks are correct, these securities will recover and generate handsome profits. This may, however, take a long time.
Short selling funds. Although some hedge funds strategies involve certain amounts of short selling, these funds focus mainly on selling short. Therefore, most of their portfolio holdings consist of various financial instruments sold short. Here, the bet is that their values decline. This strategy may also involve derivatives such as buying puts on options. (A put is a bet that the value of the underlying security, such as a stock, will decline.)
Managed futures. These funds invest in the commodities markets with the use of futures, which are financial derivatives that allow to buy or sell underlying commodities for a set price. Both long and short strategies are used.
Managed forex funds. Here investing takes place in the currency markets. These funds seek to hire star currency traders and use superior trading systems, which often are algorithms run by robots.
Multi-strategy hedge funds. Such investment vehicles pursue multiple strategies to arrive at a profit. Thus, a combination of the above strategies is used.
Funds of Funds. These are investment management companies that purchase a variety of hedge funds to arrive at the best combination of return with limited risk and volatility. The drawback is that in addition to paying fees to the funds that are added to the Fund of Funds, the investors also pay a fee to the Fund of Funds manager.
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