Hedge fund strategies are often grouped into different styles, although style definitions and perspectives vary among hedge fund managers. The universe of hedge fund strategies is vast, as is the range of risk/return profiles they offer. Portfolio construction and diversification opportunities are greatly enriched by the complementary strengths of different hedge fund strategies. Strategies such as equity market neutral, statistical arbitrage, convertible bond arbitrage, fixed income, merger, volatility and multi-strategy arbitrage, focus on relationships between securities and instruments. These strategies place an emphasis on maintaining low market exposure and consistency rather than magnitude of return. Strategies such as long/short equities, managed futures, global macro, emerging markets and distressed securities focus on outright price movements in the securities or instruments traded and tend to be more aggressive. These strategies tend to perform strongly during periods of clear upward or downward directional moves in markets.
While hedge funds share many characteristics, the range of investment styles is broad. These styles can be grouped into five main categories although there are some overlaps:
1. Equity Hedge (Long/Short)
Equity hedge funds have been the fastest growing style segment in recent years. The managers of these funds are generally stock pickers who employ both fundamental and technical analysis to invest on both the long and short side of the market. Being long means that the manager will profit when the security goes up and being short is the opposite. Most equity hedge funds will either be net long or net short depending on their view of the market direction, alternatively they might buy the best stocks and short the index to hedge against a systematic event that brings the whole market down. The target performance of these funds is high but there may be a higher degree of correlation to equity markets than other strategies.
2. Relative Value
Relative value encompasses a number of different strategies. Broadly speaking, managers that implement relative value strategies (also known as market neutral) construct portfolios that hedge out market risk as far as is possible. They do so by matching long positions to offsetting short positions in securities that are respectively under and overvalued. They attempt to make returns through exploiting pricing anomalies between securities.
Equity market neutral funds share some of the characteristics of long/short funds. However, through balancing long and short positions they seek to have minimal correlation with equity markets. These funds might, for example, be long and short of respectively under and overvalued European bank stocks
- Convertible bond arbitrage is a relative value approach that involves buying a portfolio of convertible bonds and offsetting or hedging these long positions by selling short the underlying stocks. If the stock increases in price the bonds will appreciate and if the stock falls, the short position will make money.
- Convertible bond arbitrageurs favour equity market volatility as they aim to take advantage of stock price movements to adjust their short stock hedge positions. By doing this they maintain a market neutral position and aim to capture profits.
- Fixed income arbitrage involves exploiting the interest rate spread between related fixed income instruments. A fixed income arbitrage fund would take a long position on a higher yielding fixed income instrument and a short position on the lower yielding instruments. This can be done between different maturities on the fixed income yield curve, or between different types of fixed income instruments, i.e. corporate and government bonds. Fixed income arbitrage managers tend to employ considerable leverage to magnify returns, which has resulted in some notable difficulties in the past.
3. Global Asset Allocators
Global Asset Allocators are opportunistic investors that operate throughout the world in a wide variety of markets. They may go long or short and employ varying amounts of leverage. There are two main types of asset allocators: managers of global macro and momentum-based managed futures styles.
- Macro hedge funds employ a variety of hedge strategies, but are best known for their highly leveraged trades in bond, currency and other markets. Macro fund managers study global macro economic and political developments and form views as to whether likely developments are reflected in financial markets. Should they see a compelling opportunity, they will invest accordingly. The performance of these funds varies enormously according to the investment process and predicative skills of the manager and the amount of leverage employed.
- Managed futures funds generally employ systems driven trading systems to identify and follow trends in fixed income, foreign exchange, commodity and stock index markets. Modern managed futures trading systems are highly complex and quantitatively generated. They seek to follow trends up or down across large number of markets (they typically trade around 100 markets simultaneously) and a variety of time horizons. However, some Managed futures strategies employ discretionary approaches while others focus on trend reversal, contrarian (countertrend), mean reversion and spread trading techniques. These funds trade derivative instruments such as futures contracts, options, forward contracts, swap contracts and leverage contracts. Returns vary according to the system and degree of leverage employed.
4. Event Driven
Event driven strategies seek to exploit individual corporate events. The most common styles are merger arbitrage (also known as risk arbitrage), and distressed security investing.
- Merger arbitrage funds generally invest in both parties to a merger upon its announcement. In the case of stock transactions, they ‘short’ the acquirer and buy the company being acquired. The returns of merger arbitrage funds have historically been in the region of 10-15% per annum, and have little correlation with equity markets, although they are vulnerable to market crashes.
- Distressed securities managers commonly buy the under-valued securities, or bank debt, of companies or financial distress or bankruptcy proceedings. Some managers play an active role in negotiating private deals and loans and participating in reorganisations. The returns of distressed debt funds vary, but are generally highest at times of economic recovery.
5. Funds of Funds
Funds of funds may invest in multiple (usually around 30, but sometimes more than 100) underlying hedge funds with the aim of seeking the best hedge funds available while diversifying across managers and strategies. The result is gaining the benefits of investing in hedge funds with a much more consistent and attractive risk/reward profile and removing the need for highly specialized research and monitoring resources that investing in a wide range of hedge fund requires. The value-added role that a fund of funds manager plays often hinges on the manager’s ability to provide access to the capacity of exceptional hedge fund managers that are sometimes closed to investment, as well as expertise in manager due diligence, strategy selection, portfolio construction and monitoring.
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