Hedge funds use a variety of different strategies and we can group many of these into certain categories that assist an analyst/investor in determining a manager’s skill and evaluating how a particular strategy might perform under certain macroeconomic conditions. The following are only a few classifications of hedge fund strategies and are a general overview.
The equity hedge strategy is commonly referred to as a a long/short equity and it is one of the simplest strategies to understand. In this strategy, hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity markets.
In this strategy, a hedge fund manager applies the same basic concepts mentioned in the previous paragraph, but seeks to minimize the exposure to the broad market. This can be done in two ways. If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero.
There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager’s intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks.
Either of these long/short strategies can be used within a region, sector or industry, or can be applied to market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles described here.
These are the strategies that have the highest risk/return profiles of any hedge fund strategy. Global macro funds invest in stocks, bonds, currencies, commodities, options, futures, forwards and other forms of derivative securities. They tend to place directional bets on the prices of underlying assets and they are usually highly leveraged. Most of these funds have a global perspective and, because of the diversity of investments and the size of the markets in which they invest, they can grow to be quite large before being challenged by capacity issues.
These strategies attempt to exploit mis-pricings in corporate convertible securities, such as convertible bonds, warrants, and convertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds’ risk by shorting the associated stock. In addition to collecting the coupon on the underlying convertible bond, convertible arbitrage strategies can make money if the expected volatility of the underlying asset increases due the embedded option, or if the price of the underlying asset increases rapidly.