Hedge fund strategies encompass a broad range of risk tolerance and investment philosophies within a wide array of investments, including debt and equity securities, commodities, currencies, derivatives, real estate and other investment vehicles. The horizon of hedge fund investment strategies has seen unprecedented expansion in recent years. Below is a description of some of the more common hedge fund strategies. Note that hedge fund investment terms are driven in large part by the fund’s strategy and its level of liquidity. See our article: Brief Survey of Common Hedge Fund Terms.
One of the most commonly used strategies for startup hedge funds is the long/short equity strategy. As the name suggests, the long/short equity strategy involves taking long and short positions in equity and equity derivative securities. Funds using a long/short strategy employ a wide range of fundamental and quantitative techniques to make investment decisions. Long/short funds tend to invest primarily in publicly traded equity and their derivatives, and tend to be long biased. Long/short funds also tend to have fairly straightforward investment fund terms. Accordingly, lock-ups, gates and other withdrawal terms in long-short funds are usually on the more permissive side because of the ease of liquidating positions when needed to facilitate investor withdrawals.
Credit funds make debt investments based on lending inefficiencies. Credit funds tend to follow cyclical patterns, and are most active following economic downturns and restrictions in the credit market. Credit funds include distressed debt strategies, fixed income strategies, direct lending and others.
Distressed debt involves investment in corporate bonds, bank debt, and occasionally common and preferred stock of companies in distress. When a company is unable to meet its financial obligations, or is in a liquidity crisis, its debt is devalued. Distressed debt funds use fundamental analysis to identify undervalued investments. Hedge funds that invest in distressed debt need to employ more stringent lock-up and withdrawal terms, including side pockets, (accounts to separate illiquid assets). A fund sponsor looking to form a distressed debt fund should speak with experienced legal counsel to determine whether a private equity fund would be more appropriate. Unlike hedge funds, that allow regular withdrawals, private equity funds are usually closed-ended and have a finite duration, typically between five and ten years.
Fixed income funds invest in long-term government, bank and corporate bonds, debentures, convertible notes, capital notes, and their derivatives, which pay a fixed rate of interest. Many fixed income funds have lower risk tolerances than distressed debt funds and place capital preservation as a higher priority, leading to more diversification and volatility-reducing strategies. A common fixed income hedge fund strategy is fixed income arbitrage, discussed below.
Arbitrage strategies seek to exploit observable price differences between closely-related investments by simultaneously purchasing and selling investments. When properly used, arbitrage strategies produce consistent returns with low risk. However, because price inefficiencies between investments tend to be slight, arbitrage funds must rely heavily on leverage to obtain significant returns. Due to heavy use of leverage, some arbitrage firms have suffered monumental losses when pricing differences unexpectedly shifted (including Long Term Capital Management, the infamous fixed income arbitrage fund from the 1990s that suffered catastrophic losses and had to be bailed out by a government-brokered consortium of Wall Street banks).
Fixed Income Arbitrage
Fixed income arbitrage seeks to exploit pricing differences in fixed income securities, most commonly by taking various opposing positions in inefficiently priced bonds or their derivatives, with the expectation that prices will revert to their true value over time. Common fixed income arbitrage strategies include swap-spread arbitrage, yield curve arbitrage and capital structure arbitrage.
Convertible arbitrage seeks to profit from price inefficiencies of a company’s convertible securities relative to its company’s stock. At its most basic level, convertible arbitrage involves taking long positions in a company’s convertible securities while simultaneously taking a short position in a company’s common stock. Although simple in theory, proper execution of convertible arbitrage strategies requires careful timing to avoid losses. Furthermore, the increasing popularity of convertible arbitrage has had the effect of diminishing available price inefficiencies, making it difficult to achieve significant returns without using extensive leverage.
Relative Value Arbitrage
Relative value arbitrage, or “pairs trading” involves taking advantage of perceived price discrepancies between highly correlated investments, including stocks, options, commodities, and currencies. A pure relative value arbitrage strategy involves high risk and requires extensive expertise.
Merger Arbitrage involves taking opposing positions in two merging companies to take advantage of the price inefficiencies that occur before and after a merger. Upon the announcement of a merger, the stock price of the target company typically rises and the stock price of the acquiring company typically falls. Merger arbitrage is a form of event-driven hedge fund strategy, discussed below.
Event-driven strategies are closely related to arbitrage strategies, seeking to exploit pricing inflation and deflation that occurs in response to specific corporate events, including mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, liquidations, bankruptcy and other events creating inefficient stock pricing. Event-driven strategies require expertise in fundamental modeling and analysis of corporate events. Examples of event-driven strategies include: merger arbitrage, risk arbitrage, distressed debt, and event-based capital structure arbitrage.
Quantitative (Black Box)
Quantitative hedge fund strategies rely on quantitative analysis to make investment decisions. Such hedge fund strategies typically utilize technology-based algorithmic modeling to achieve desired investment objectives. Quantitative strategies are often referred to as “black box” funds, since investors usually have limited access to investment strategy specifics. Funds that rely on quantitative technologies take extensive precautions to protect proprietary programs.
Global macro refers to the general investment strategy making investment decisions based on broad political and economic outlooks of various countries. Global macro strategy involves both directional analysis, which seeks to predict the rise or decline of a country’s economy, as well as relative analysis, evaluating economic trends relative to each other.
Global macro funds are not confined to any specific investment vehicle or asset class, and can include investment in equity, debt, commodities, futures, currencies, real estate and other assets in various countries. Currency traders rely heavily on global macro strategies to forecast relative currency values. Likewise, interest rate portfolio managers, which trade instruments that are keyed into sovereign debt interest rates, are heavily involved with global macro fundamental analysis.
Multi-strategy funds are not confided to a single investment strategy or objective, but use a variety of investment strategies to achieve positive returns regardless of overall market performance. Multi-strategy funds tend to have a low risk tolerance and maintain a high priority on capital preservation. Even though multi-strategy funds have the discretion to use a variety of strategies, we have found that fund managers tend to focus primarily on one or more core investment strategies.
Capital Fund Law Group has authored numerous investment fund publications, including instructive eBooks, white papers, blog posts and sample offering document excerpts with illustrative footnotes. These complementary downloads are dedicated to helping fund managers understand the legal fundamentals of launching and operating an investment fund.
Forming and Operating a Hedge Fund | an eBook
Written by the managing partner of Capital Fund Law Group, Forming and Operating a Hedge Fund provides an in-depth guide to assist emerging hedge fund managers through the process of successfully structuring, launching, and raising capital for a domestic or offshore hedge fund. Throughout the eBook, it highlights pitfalls that fund sponsors should watch for and suggests best practices to safely and effectively navigate the process of forming and operating a hedge fund.
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Capital Fund Law Group is a boutique investment law firm focused on advising emerging and established investment funds on all aspects of formation and operation. We provide predictable flat-fee services for most of our engagements. Our legal team has extensive experience advising hedge funds, real estate funds and private equity funds throughout the United States in various structures and strategies. We also prepare debt and equity private placement offerings for companies in all major industry sectors.
FORMING A FUND