Hedge funds use a wide variety of approaches and strategies for investing. Based on their investment approach, goals, and securities that they employ they are classified into different types of hedge funds. The sheer range of strategies is one of the key features that hedge funds provide to their investors.
Common hedge fund strategies are long/short equity, global macro, relative value, event-driven, activist, and trend-following/CTA hedge funds. Most hedge funds are not focused on only one strategy, and investing in one financial security. They tend to offer diversification of investments by using different strategies. But, usually, they have a preferred investment strategy, which in turn defines the fund to a type.
Each type of hedge fund has unique features, upsides, and downsides. This helps potential investors to choose where they will invest. Stay with us, and you may find just the perfect type of investment for your liking.
Core Hedge Funds Types
Hedge fund investing is a complex investing discipline. Hedge funds can employ several strategies and trade with different securities. That offers an almost limitless potential for portfolio diversification. There are 6 core hedge fund types based on their strategies. All of them carry specific risks and benefits. Understanding the differences between hedge funds before you decide to invest is important.
Long/Short Equity Funds
Long/short equity funds use an equity strategy that combines long and short positions in the equity market. They buy undervalued or stocks that show promise. At the same time, they are selling overvalued or potentially weak stocks. These funds tend to profit from the relative performance of long and short positions. They avoid relying upon the overall direction of the stock market.
Since this type of investing comes with increased risks, hedge funds employ different risk management strategies. Most long/short equity funds aim to be market-neutral. This means that funds want to balance their short and long positions to minimize exposure to sudden market movements.
Another way to minimize risk is to use stop-loss orders. They are used in both short and long positions. These orders trigger an automatic sale or buyback when a stock reaches a level that was defined earlier. This technique lowers the possibility of huge losses.
Long/short equity funds also have to pay attention to concentration risk. A common tactic to lower it is with the use of position sizing. Portfolio managers must be careful when assigning capital to specific investments. A manager must ensure that no single position can have a significant impact on the overall performance of the portfolio.
Global Macro Hedge Funds
Global macro hedge funds focus on investment decisions based on macroeconomic factors that have an impact on the global level. Macro funds seek to gain profit from wide economic events, geopolitical decisions, and switches in market trends.
Global macro funds trade in different securities like bonds, stocks, commodities, and currencies. This guarantees wide portfolio diversification and a lower chance of potential losses.
Macro funds are characterized by their in-depth and careful analysis of macroeconomic indicators. Those include political factors like elections and the introduction of new laws and regulations. Also, changes in the global markets are a great opportunity to exploit sudden fluctuations in the values of securities.
Macro hedge funds aim to invest in currencies, merging companies, or commodities. Their values can undergo a major fluctuation often under the impact of global events. That is why these funds employ managers who know and understand the global economic market. They need to know the political and economic conditions and ways to exploit them.
Since macro hedge funds are not geographically limited, that puts additional investment risk. They can be a subject of high-level of volatility. Especially if their macroeconomic predictions and views prove to be wrong. That is why they employ several risk management techniques. The most common are position sizing and stop-loss orders.
Relative Value Hedge Funds
Relative value hedge funds aim to benefit from pricing discrepancies or relative mispricing between related securities, assets, or markets. Fund managers tend to identify investment possibilities where the relative value of one asset is not aligned with another. The fund generates positive returns from the convergence or divergence of these values.
The focus of relative value hedge funds is on pricing discrepancies. They occur due to market inefficiencies, and supply and demand imbalances. They diversify their portfolios by investing in multiple related securities, assets, or markets. This way the fund wants to spread the risk and minimize the exposure of specific investments.
These funds take both long and short positions. They also employ pairs trading. This hedge fund technique involves identifying two companies with similar backgrounds. Their stock prices are often moved up and down at the same time. If shares of one of the companies suddenly lose value, they buy the shares of both companies. Then they wait for the value of the shares of the first company to go up.
Often techniques that these funds use are arbitrage opportunities. Among those techniques are convertible arbitrage, fixed income arbitrage, and merger arbitrage. Convertible arbitrage exploits the differences between convertible bonds and their underlying equity. Fixed income arbitrage focuses on exploiting differences between interest rates. Merger arbitrage tends to profit from mergers and acquisitions.
Relative value hedge funds are interesting to investors who are not primarily looking to earn from traditional asset classes. They aim to capitalize on pricing discrepancies in financial markets.
To successfully invest in this type of fund, managers must conduct thorough due diligence and careful risk management. Fund managers must be experts in global market trends, so they can identify pricing discrepancies.
Before you decide to invest with these funds you should check their risk management practices. Other key factors are investment performance history and management team.
Event-Driven Hedge Funds
Event-driven hedge funds take advantage of temporary mispricing. They are caused by major corporate reorganization, restructuring, merger, bankruptcy, or acquisition. These events often have the potential to create investment opportunities for the intelligent fund manager. Event-driven strategies involve taking positions so they can exploit these special conditions.
Managers who work in these funds are experts in analyzing corporate activities. They can identify the effects that specific activities can bring to the market. Managers overlook these decisions and their possible impact on the value of the securities. Then the managers decide to invest based on the current stock price against the possible price of the stock after the action takes place.
Event-driven hedge funds aim to generate alpha. This means achieving returns that exceed those of the broader market by capitalizing on event-related price changes. Also, they often engage in risk arbitrage. The fund takes long and short positions in securities related to a specific event like a merger or acquisition. They want to capture the difference between prices in the two positions.
Investing in distressed securities is not a popular investment strategy but, event-driven hedge funds sometimes use it. The fund managers want to gain profit from potential turnarounds or debt restructurings. Another tactic that they use is activist investing. They focus on taking important positions in the companies and influencing a change in their business direction. The goal is to increase the value of the companies and earn high returns to the investors.
Trend Following/CTA Hedge Funds
Trend-following, or Commodity Trading Advisor hedge funds use strategies that are based on identifying and investing in the current hedge fund trends. They seek to buy securities that are trending upward and sell short assets that are trending downward.
They often use momentum trading strategies to identify market trends. They will focus on finding the securities with recent strong and unexpected performance. Then they will trade in the same direction as the existing trend.
Fund managers often base their portfolios on market conditions. They want to exploit the most positive trends while minimizing the risk of investing in the unpopular and downward trends. Managers also use quantitative models and historical data analysis. They use massive amounts of data to identify trends and make trading decisions.
These funds are known for their ability to make high profits from current market trends. They generate positive returns with a low correlation to traditional asset classes. The problem with these investments can be periods of low performance. This is often the case when markets are characterized by low volatility or unusual price movements.
Activist Hedge Funds
These types of hedge funds are characterized by taking an active role in the management of the companies they invest in. Traditional hedge funds aim to generate returns through buying and selling securities. Activist hedge fund managers on the other hand want to influence the business direction and strategy in the targeted company.
The most common approach of activist hedge funds is acquiring significant stakes in a company’s stocks. Then from the ownership position, they can work on guiding and changing the company’s policies. The goal is to raise the value of company stocks before selling them.
Once they acquire a portion of ownership the managers use different strategies to change the business course of the company. The first on the list is usually a change in management structure if the current leadership is not maximizing the company’s potential.
Managers often push for a change in the capital structure. That can lead to share buybacks and restructuring of the debt. Another way to increase the stock value is by recommending strategic shifts like mergers or acquisitions. Managers also conduct a deep analysis of the operation efficiency. Based on those they can implement cost-cutting measures or other methods to improve profitability.
Activist hedge fund strategies in some cases bring positive results to the target company. But, often their strategies are considered to be controversial. Fund managers frequently focus on short-term gains over the long-term health of a company. In other cases, managers are caused to focus on their interests, while neglecting other stakeholders.
Top Types of Hedge Funds
No one can determine the best types of hedge funds around. Even among professionals, the opinions are divided. The popularity of the particular hedge fund sector may vary over time. That can depend on the market conditions and the preferences of the investors.
But, among different types of hedge funds, these are constantly popular due to their potential high returns, and risk management:
- Long/short equity funds
- Global macro funds
- Event-driven funds
- Arbitrage funds
- Quantitive funds
Take a Loot At The Beginner’s Guide to Hedge Fund Investing: 7 Common Strategies You Need to Know:
Strategies Employed
Hedge funds rarely employ one strategy. They invest in different hedge fund strategies that are essentially different. The most compound differences are in the construction of the portfolio and risk management techniques.
The most common strategies used are equity, relative value, event-driven, macro, credit, niche, and alternative risk premia.
Equity Strategy
This is the most frequently used hedge fund strategy. With equity strategies funds take long positions in stocks recognized as undervalued and short positions in stocks considered overvalued. With investments in long positions, hedge funds buy and hold securities when they expect their value to grow in the future. With short positions, the fund borrows a security and sells it at a high price. The fund expects its value to fall in the future. Then they buy it and return it to the owner with a profit. Equities are heavily influenced by macroeconomic factors. This is making them a riskier type of investment when compared to currency and bonds. There are several sub-types of equity strategies, like long/short equity, market-neutral, long-bias, short-bias, and value-oriented
Event-driven Strategies
These strategies are based on conducting trades of the securities of specific companies. This strategy aims to exploit the inefficiencies in the market or price fluctuations that can happen before or after a corporate event. When using this strategy funds are primarily investing in distressed debt, merger arbitrage, or other complex scenarios that can have a sudden impact on value.
Relative Value Strategies
Funds use this strategy when they aim to profit from price differences between two closely related securities. This strategy carries a similar risk to the event-driven strategy, just on a smaller scale. This strategy is barely burdened with systematic risk, which is predominant in equity strategies. Relative value strategy brings profits during normal market conditions. It is characterized by low volatility and modest returns. These investments frequently bring smaller profits, and sometimes are hit with major losses.
Macro Strategies
They aim to profit from major market swings that are the result of political or economic events. They participate in all major securities markets like equities, bonds, currencies, and commodities. They maintain both long and short positions based on the current global market environment.
Managed Futures
This strategy is employed by commodity trading advisers (CTAs). They use a similar investing strategy to the macro strategy type. They often use a propriety trading system to predict market trends. Based on those predictions they choose where will they invest. These funds take long and short positions in futures contracts in metals, agricultural products, and other soft commodities. They also invest in foreign currency and US Government bond futures. With this strategy, the portfolio volatility is reduced. The investors can earn a profit in any market environment.
Credit Strategies
Hedge funds invest primarily in debt instruments. They aim to take advantage of inefficiencies in lending and take long or short positions in the price of the security. To properly employ credit strategy, funds must conduct a quantitative analysis. That way they can identify specific risks related to credit instruments, such as default risk, credit spread risk, and illiquidity risk.
Risks and Challenges
All investment vehicles come with their set of risks and challenges, and hedge funds are no different. Before the investor decides to invest in a hedge fund they should consider the common risks:
- Level of transparency. Hedge funds offer lower levels of transparency when compared with traditional investment funds like ETFs and mutual funds. Depending on the hedge fund and the manager, they may not share information about strategies and investment risks. This makes the investment process less transparent to the investor
- Liquidity risk. Hedge funds often invest in less liquid securities or markets. When the specific market is in stress that makes it difficult for the fund to sell their downward positions. If the fund misses the opportunity to let loose a bad investment that can lead to massive losses. This risk comes combined with the risk of lockup and redemption periods. Depending on the fund investors may need to endure one or more years without access to their investment. Even without the lockup period, investors can redeem their investments only at specific times. The fund’s policy may determine annual, quarterly, or monthly investment redemption
- Leverage risk. All types of hedge funds often use leverage to increase the possible returns. Leverage can multiply the return, but it can also increase the chance of significant losses. The target market can quickly change, which can draw a leveraged investment to major problems
- Other high-risk strategies. To amplify their returns hedge funds commonly use risky strategies. Those include derivatives trading, short selling, and arbitrage. These strategies can be very complex to pull off. In a case of bad execution, it can lead to large losses
- Manager risk. The knowledge, expertise, and experience of the fund manager are crucial. If the manager makes a bad decision that can lead to loss of investment. That is why it is important to do a deep check of the fund and its employees before investing
- Market risk. Most hedge fund strategies take a clear and deliberate stance on the direction of market movements. These strategies make calculations and assumptions on future prices of securities. That puts investments at risk from sudden market changes. Opposite to that, there are more market-neutral strategies. They aim to gain returns that are not under large pressure from the current state of the market.
FAQs
What Types of Strategies Do the Biggest Hedge Funds/ Prop Trading Firms Use to Make Money?
The strategies of big hedge funds and prop trading firms may vary. Also, strategies tend to evolve. That is why it is difficult to define the winning strategies. But from an analysis of these companies, it is noted that they often use a combination of these strategies:
- Global macro strategy
- High-frequency trading
- Quantitive strategies
- Even-driven strategies
- Long/short equity
- Market making
- Algorithmic trading
- Trend following strategies.
What Is the Most Common Type of Hedge Funds?
Long/short equity funds are historically the most common type of hedge funds. This trend is not constant, and it can vary depending on the state of the market.
Conclusion
Choosing an investment vehicle is a difficult task alone. Once you choose a specific investment vehicle, like a hedge fund, then begin diving into details. You, as a potential investor first need to know your goals. What returns do you expect? And how long are you willing to wait for them?
Based on those factors you can start assessing specific investment strategies. Based on the strategy that you find compelling you should choose a hedge fund. Hedge funds usually use several investing strategies, and you need to find the best choice for your needs. Talk with the managers and find the perfect fund profile to fulfill your investment expectations.
