It’s important to join a hedge fund with an investment strategy that fit you in order to have longevity in this career. Today we’ll go over the most popular hedge fund strategies. Let’s start with an overview of the hedge fund industry.
Hedge funds are private investment vehicles aimed to generate positive absolute returns for institutional clients and high-net-worth individuals.
Hedge funds are usually structured as partnerships. Portfolio managers are typically general partners of the fund with investment decision-making responsibilities. They hire research analysts to cover existing and potential investments, who are typically aligned by asset class (for example, debt vs. equity), industry (financials vs. consumer), and geography (emerging markets vs. U.S.).
The hedge fund industry has grown substantially over the past 2 decades and can no longer be considered a homogeneous asset class. There are estimated 9,000 hedge funds in the U.S. today with $2 trillion in assets under management.
Hedge Funds vs. Mutual Funds
Hedge funds are the modern, sexier sibling of the traditional mutual funds. Hedge funds are generally less risk-averse, more opportunistic, and more nimble.
For example, mutual funds mostly make mostly long-only investments, while hedge funds frequently short stocks. Mutual funds typically have a diversified portfolio of 60 – 80 positions, while hedge funds are more concentrated vehicles with 20 – 40 holdings. Hedge funds also use leverage to boost returns, while mutual funds do not.
Popular Hedge Fund Strategies
Within the investment industry, there are many different strategies that can be utilized in an attempt to get a greater return on the capital invested. Fund strategies typically fall into 1 of 3 categories: directional, relative value, and event-driven.
Which hedge fund strategies best align with your investment philosophy and career interest? Let’s go over the most popular hedge fund strategies to drill down on what fits you best.
The most common fundamental equity strategy today. In a long/short portfolio, you would buy stocks of companies that are expected to outperform while sell short stocks you expect to underperform.
Long/short portfolios have low correlations to the market, and clients are attractive to long/short funds because they generate absolute returns independent of the market performance.
Long/short funds could also be net long, net short or market neutral. Fundamental company research and stock picking are keys to success at a long/short fund.
Market neutral funds are similar to equity long-short funds; they seek returns that are totally independent of market performance. These funds attempt to minimize or eliminate market volatility. One strategy would be holding equal long and short positions within the same sector.
The important distinction between market neutral and long/short is that market neutral portfolios strictly aim for a portfolio beta of 0, while long/short portfolios can have a net long bias or a net short bias depending on the portfolio manager’s market view.
Similar to long/short, market neutral funds may use leverage to enhance returns and they may use derivatives to hedge the overall portfolio.
Another long/short strategy achieved through buy convertibles and shorting their underlying stocks.
A typical long/short portfolio typically consists of either all equity or all debt. However, for a convertible arbitrage portfolio, you would buy the convertible debt of a company and short-sells the stock of the same company.
The convertible debt is a bond that can be converted into stock at some point in the future. This strategy attempts to isolate the interest coupon of a convertible debt by hedging out the equity call option of the convertible debt. Convertible valuation and option pricing are key skills to have in addition to equity analysis.
Distressed funds purchase bank loans or high yield debt of companies that are facing potential bankruptcy or restructuring.
Funds typically purchase bank debt or bonds, but trade claims, preferred stock or even common stock are also fair game if the prices are right. Because the company is in distress and investors are well aware of the issues, the securities the fund is looking to purchase are selling at deep discounts.
Emerging market funds have a wide mandate. Their investments range from sovereign debt and currencies to equities of companies within emerging markets.
Emerging market funds are very attractive for analysts who have a language or cultural skillset. Investing in Asian countries – China, Japan, Taiwan – has been extremely popular as of late.
There is a wide range of corporate events that can move a company’s stock significantly in a short timeframe. An “event” could include an IPO, a merger, an earnings disappointment, an acquisition, a drug approval, or a spinoff.
The idea is that when the news comes out, price inefficiencies tend to occur before and after such aforementioned events. Event-driven funds attempt to take advantage of the inefficiencies to boost returns.
Long-only funds mirror the traditional mutual funds and only go long on stocks. This style of trading is more like a traditional mutual fund than any other hedge fund strategy.
Portfolio managers managing this type of fund typically take a longer-term view than their long/short counterparts. The long-only space is fairly saturated. Thus the investment performance of long-only portfolio managers must stand out considerably if they are going to attract investors and in order to be able to justify their fees.
The opposite of long-only, equity short funds look to benefit from stocks that are expected to fall in price by short-selling the stock.
There are primary two types of funds in this group: short-only and short-biased funds. A short-only fund can only make bearish bets while a short-biased fund has the majority of its assets tied up in bearish holdings.
These funds can be extremely profitable, especially during an overall bear market. Jim Chanos is a prime example of a short-biased investment strategy that has generated strong returns over the years.
Similar to long/short equity funds, fixed-income arbitrage funds take advantage of price differences between two fixed-income securities.
Securities involved in fixed-income arbitrage can include corporate bonds, municipal bonds, treasuries and credit default swaps. These funds tend to have a high batting average on their trades with smaller gains. The losses they take can be large but tend to be less frequent.
Global macro funds are among the most diverse types of hedge funds. They can invest in stocks, bonds, currencies, and commodities.
Regardless of the investment vehicles that are being used, at the heart of the strategy is making macroeconomic bets and searching for global opportunities.
These funds look to invest in situations created by changes in government policy, economic policies and interest rates. Macro funds tend to use derivatives and can be highly leveraged.
Risk arbitrage funds simultaneously buy and sell the stocks of two companies undergoing an acquisition or merger.
When an acquisition or merger is announced, the stock of the target company typically jumps in price but trades below the offer price. The discount is due to the uncertainty of whether the merger would go through. Risk Arbitrage analysts pour through legal documents and assess regulatory approval risks to profit from this price discount.
Merger arbitrage and risk arbitrage are interchangeable terms that describe the same strategy.