As we've explored in the previous lessons, hedge funds cannot be described as a single asset class. Hedge funds invest in a diverse group of strategies that differ considerably according to the method of portfolio construction and risk management techniques. In this section, we'll find out more about the individual strategies.
While no two hedge funds are the same, most generate their returns by investing in line with a specific top-level strategy: equity, relative value, event driven, macro, credit, niche, and alternative risk premia.
Equity Strategies
The most prevalent of the hedge fund strategies, equity strategies hedge funds take long positions in stocks perceived as undervalued and short positions in stocks considered overvalued.
Equities’ correlation with macroeconomic factors mean they are seen as a riskier class for investment than cash and bonds. They are highly susceptible to systematic risk factors (i.e. risks associated with the broader stock market), for example inflation, which can negatively impact future cash flows. Investors in equity strategies hedge funds also need to consider the risks associated with correlation to other equity investments held within their portfolio.
Equity strategies can be undertaken in a variety of ways depending on the desired amount of market exposure. Explore the drop-down to find out more.
Long position
In a long position, the fund buys and holds securities with the expectation that the assets will rise in value.
Short position/short selling
In a short position, the fund borrows a security and sells at a high price with the expectation of buying it back at a lower price in the future and returning it to the lender.
Event Driven Strategies
Characteristically, event driven strategies hedge funds undertake trades in the securities of specific companies, seeking to exploit pricing inefficiencies that may occur before or after a corporate event. The fund will invest in order to profit when the expected event takes place as predicted. Such events can include earnings calls, bankruptcy, mergers & acquisitions, recapitulations, or spin-offs. Depending on the event, the exact strategy of the fund will differ.
Click on the drop-down to read more about each strategy.
Relative Value Strategies
Relative value strategies generate profits by capturing price differences between two closely related securities. These strategies therefore tend to use arbitrage.
Relative value strategies bear similar risk to event driven strategies, but on a smaller scale. They face minimal systematic risk, which contrasts with equity strategies. Traditional relative value strategies funds tend to profit during normal market conditions with less volatility and returns, usually making small, frequent profits with occasional large losses.
Explore the drop-down for individual relative value strategies.
Capital Structure Arbitrage
What is Arbitrage?
Arbitrage is the simultaneous buying and selling of an asset in different markets or in derivative forms in order to profit from differences in the price.
Macro and Managed Futures Funds
Macro strategies hedge funds are actively managed funds with the primary aim of profiting from the broad market swings caused by political or economic events. Macro funds tend to participate in all major markets – equities, bonds, currencies, and commodities – using financial instruments to maintain long and short positions based on their research of the global market environment.
Managed futures funds, run by commodity trading advisers (CTAs), invest in a similar manner. These funds tend to use a proprietary trading system to forecast market trends and determine which trades to make. Managed futures funds take long or short positions in futures contracts across metals, grains, equity indices and soft commodities, as well as foreign currency and US Government bond futures. These funds offer the potential for reduced portfolio volatility and the ability to earn profit in any economic environment.
Commodity Trading Advisors (CTAs)
CTAs advise fund managers, providing buy or sell recommendations across commodity, currency, and options markets. They often receive payment through profit generation for their expertise.
Credit Strategies
Credit strategies hedge funds invest solely or primarily in debt instruments, with the aim of profiting from inefficiencies in lending, taking long or short positions in the price of the derivative. Credit funds require significant quantitative analysis as they look to exploit specific risks related to credit instruments, such as default risk, credit spread risk, and illiquidity risk.
Explore the drop-down for more information on credit strategies.
Niche Strategies
Niche strategies hedge funds concentrate on specific, small market niches. Explore the drop-down menu to see examples of niche strategies.
Alternative Risk Premia
Historically, the alternative risk premia strategy was treated as complementary to the existing core strategy utilized by a hedge fund manager, but in recent years large institutional investors have begun to use the strategy as an investment option in its own right.
Similar to a multi-strategy fund, alternative risk premia is an actively managed strategy that invests long and short across multiple asset classes, such as equities, fixed income, forex, commodities, and interest rates. The strategy aims to generate returns above the risk-free rate – the theoretical rate of return an investment can produce with zero risk – by taking on the risk of a given investment. Often systematic, trading many positions each day means that investors are provided a highly liquid offering, typically with a lower fee than more sophisticated hedge fund strategies.
In this lesson, we discovered the many strategies deployed within hedge fund investments. From equity and event driven strategies to macro and managed futures funds, there are a multitude of different ways investors can allocate to hedge funds.
