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. Hedge fund investment terms are driven in large part by the fund’s strategy and its level of liquidity. To learn more about forming and operating a hedge fund, we encourage you to read our eBook, Forming and Operating a Hedge Fund.
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 reasonably straightforward investment fund terms. Accordingly, lock-ups, gates, and other withdrawal terms 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
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 devalues. 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. They have a finite duration, typically between five and ten years.
- FIXED INCOME
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 conventional 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 shifted unexpectedly. One of the more memorable examples of this type of loss was Long Term Capital Management, the infamous fixed income arbitrage fund from the 1990s. Long Term Capital Management suffered catastrophic losses. It 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. Typically, fixed income arbitrage strategies include swap-spread arbitrage, yield curve arbitrage, and capital structure arbitrage.
- CONVERTIBLE ARBITRAGE
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. Convertible arbitrage seeks to profit from price inefficiencies of a company’s convertible securities relative to its company’s stock. Although simple in theory, proper execution of this strategy requires careful timing to avoid losses. Increasing in popularity, convertible arbitrage has effectively diminished 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
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 usually 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. Among these can include mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, bankruptcy, and other events creating inefficient stock pricing. Event-driven strategies require expertise in fundamental modeling and analysis of corporate events. Some examples of event-driven strategies are merger arbitrage, risk arbitrage, distressed debt, and event-based capital structure arbitrage.
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 ordinarily 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. The global macro strategy involves 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. They 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 have the discretion to use a variety of investment strategies to achieve positive returns regardless of overall market performance. They are not married to a single investment strategy or objective. Multi-strategy funds tend to have a low-risk tolerance and maintain a high priority on capital preservation.