Are you considering investing in a hedge fund? Then, you
must first understand the fundamentals of these funds, how they make money, and
the amount of risk tolerance that you might need. Here are some of the
strategies that are most commonly used in hedge funds.
Long/Short Equity
The very first hedge fund was launched in 1949 using a
long/short equity strategy. This strategy has a simple concept, which is that
investment research results on winners and losers, so why not place bets on
both?
Hedge fund
managers using this strategy can decide to purchase the stocks they consider to
be undervalued or sell the short stocks they consider to be overvalued. Most of
the time, doing this will result to the fund being exposed to the equity
markets.
Credit
Credit hedge funds often focus on the credit rather than
interest rates. There are numerous fund managers who decide to sell short
interest rate futures or Treasury bonds in order to hedge their rate exposure. Most
of the time, you can rely on the credit hedge funds to prosper during times
when credit spreads are narrow which mostly happens during periods of robust
economic growth. On the other hand, if the economy slows and the spreads blow
out, losses may be suffered.
Short Only
If you tend to err more towards the pessimistic side of
things, then the short only hedge funds might be the ones for you. These are
also great against bear markets, but are not for the faint of heart.
Market Neutral
Hedge funds suing the market neutral strategy aim for zero
net-market exposure. This strategy has lower risk as compared to long-biased strategies,
but you should remember that the expected returns are also considerably lower
as well.
When using this strategy, hedge fund managers can apply the
same basic concepts as long/short equity but minimize the exposure to the broad
market. There are two ways you can choose from when implementing this strategy.
If the amount of investment in both long and short positions are equal then the
net exposure of the fund would be zero.
The other option is to have zero beta exposure. Hedge fund
managers will be aiming for investments in both long and short positions in
order for the beta measure of the overall fund to stay as low as possible.
In either market neutral strategies, the aim is to remove
any impact that the market movements may have on the fund. Additionally, the
fund manager will rely solely on his or her ability to pick stocks.
Convertible Arbitrage
Convertibles are considered to be hybrid securities since
they combine a straight bond with an equity option. Simply put, a hedge fund
using convertible arbitrage is typically long on convertible bonds while taking
a short position on a proportion of the shares that they convert into.
Fixed-Income
Arbitrage
Hedge funds using this strategy take returns from risk-free
government bonds which can eliminate the credit risk. Normally, they use high
leverage in order to bolster their supposed modest returns. But by definition,
the risk of loss is also higher if the manager ends up being wrong.
Learn more about what hedging is.
Merger Arbitrage
Basically, this is a riskier version of the market neutral
strategy. The returns from this strategy are taken from takeover activities. Once
a share-exchange transaction is announced, the hedge fund manager can choose to
buy shares in the target company as he or she sells short the buying company’s
shares at the ratio prescribed by the merger agreement.
There are certain conditions that the deal must abide to such
as regulatory approval and a favorable vote made by the target company’s
shareholders.
Event Driven
Hedge fund using event driven strategies buy the debt of the
companies in financial distress or those who have already filed for bankruptcy.
When using this strategy, you need to exercise a considerable amount of
patience. Corporate reorganizations can play out for months or years, a time
when the operations of the troubled company might further deteriorate.
Global Macro
When comparing to any and all hedge fund strategies, the
global macro strategy has the highest risk/return profile. When using this
strategy, the fund is invested in stocks, bonds, currencies, commodities,
options, futures, forwards and other derivative securities.
Conclusion
There are various hedge fund strategies that you can choose
from. A lot of them are not yet discussed here, but the ones that are discussed
are conveyed in a way that can be easier to understand but may be more
complicated that they seem. There are also hedge funds that use more than one
strategy, mostly depending on the assessments of the opportunities they face.
Just remember to gather as much information as you can before finalizing your
decisions.
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