Hedge Fund Strategy

Hedge Fund Strategy

Hedge Funds

Hedge funds are alternative investments that exploit market opportunities to their advantage and are generally only accessible to accredited investors. They require far less regulation by the Securities and Exchange Commission (SEC) than other such mutual funds. There are funds that require a larger initial investment than others and withdrawals usually take time. Most hedge funds are also illiquid, meaning investors have to invest their money over a longer period of time.

Hedge Fund Strategy

Different hedge fund strategy models are therefore being used to enable investors to generate active returns. Potential hedge fund investors need to understand how these funds make money and the risk / reward ratio they take when they invest in these financial products.

Hedge Fund Strategy: Leverage

Hedge funds are versatile investment vehicles that can use leverage, derivatives and short positions in stocks. Hedge funds therefore have the opportunity to achieve active returns for their investors through different strategies. Although no hedge fund is the same, most can achieve returns using the specific strategies outlined below. The strategies of hedge funds range from long and short share prices to market neutral ones.

Long/Short Equity

The strategy, initiated in 1949 by Alfred W. Jones, is still in use and is the first hedge fund to opt for a long-short equity strategy. Equity research turns up expected winners and losers, so why not take a position on both?

Take long positions on expected winners as collateral to finance short positions in the losers. The combined portfolio creates more opportunities for idiosyncratic (i.e. stock-specific) gains, reducing market risk with the shorts offsetting long market exposure.

Market Neutral Hedge Fund Strategy

Market-neutral hedge fund aims for zero net market exposure. This means managers generate their entire return from stock selection. This strategy has a lower risk than a long-biased strategy—but the expected returns are lower, too.

Because most hedge fund managers do not hedge their entire long-term market value against their short positions, long-term and short-term hedge funds do not have a net long-term market risk. Both have the same market value and both hedge against short to long-term volatility.

This means that the manager gets his entire return from stock selection, but not from short-term market risk, which can have a negative impact on the performance of the portfolio. This strategy has a long-term, biased strategy, but it depends on stock selection, which only works if stocks rise and fall in unison. Expected returns are also lower.

Merger Arbitrage Hedge Fund Strategy

Merger arbitrage is often considered one kind of event-driven hedge fund strategy. Before or immediately after a share-exchange transaction is announced, the hedge fund manager may buy shares in the target company and short sell the buying company’s shares at the ratio prescribed by the merger agreement.

However, the inherent risks in merger arbitrage hedge fund strategies  are that any deal is usually subject to certain conditions:

  • Regulatory approval
  • A favorable vote by the target company’s shareholders
  • No material adverse change in the target’s business or financial position

Acquisition activity is determined by a number of factors, including the size of a company’s market capitalization, the quality of its assets and the degree of liquidity of its portfolio.

After announcing a share transaction, hedge fund managers can buy shares in the offeree company and then sell shares in the purchased company in the ratio required by the merger agreement. During the transaction, the target company’s shares will be traded at a discount to the cash payable at the time of closing or at a spread that compensates investors after the closing of the transactions. Managers must hedge against a number of factors, including the size of their portfolio, the quality of their assets, and the level of liquidity in their portfolio.

Because merger arbitrage is accompanied by uncertainty, hedge fund managers must carefully evaluate each transaction and accept the risks involved. If the deal goes through, the spread will yield a return no matter what happens in the market, but buyers will have to pay a large premium to the share price, so investors can expect a big loss in the event of a collapse. Of course, this strategy carries significant risks and can cause investors a lot of pain.

Participation in this type of strategy must therefore be fully informed of the risks and potential benefits.

Convertible Arbitrage Hedge Fund Strategy

Convertible arbitrage hedge funds typically consist of two types of investments: convertible bonds and convertible stock options. A convertible bond is a hybrid insurance that combines a direct forward bond with a stock option. If a merger is planned, it can be done without any conditions imposed by a company, but it can ultimately be prohibited by regulation.

Managers try to maintain a “delta neutral” position, in which bond and equity positions are balanced against each other during market fluctuations. To maintain delta neutrality, traders must increase their hedging and short-sell more stocks as prices rise, and short-sell stocks to reduce hedging when prices fall. This forces them to either buy low or sell high and vice versa, for a total return of 10% or more per year.

Funds thrive when volatility is high or declining, but they struggle when it soars, as in the case of the S & P 500. The more stocks jump, the more opportunities there are to adjust to volatility that can cause a sharp rise or fall in the share price.

Convertible arbitrage also carries an event risk: if the issuer becomes a takeover target, managers can adjust the hedge, but this can lead to significant losses, especially if a stock loses value.

Event Driven Hedge Fund Strategy

This type of strategy works best during periods of economic strength when business activity tends to be high. This event-oriented strategy lies below the limits of equities and fixed income, but it is still a good investment.

Hedge funds use this strategy it to buy shares in companies that are in financial difficulty but have not yet filed for bankruptcy. If the company has not yet filed for bankruptcy, managers can sell short capital and bet that the shares will fall if it files for bankruptcy by negotiating a share swap. Managers often focus on companies that are already bankrupt and whose senior debt has been repaid at face value. For companies that are already bankrupt, subordinated debt, which is eligible for lower recoveries in the event of a restructuring, can provide better protection.

Corporate restructuring does not always go as managers plan, and changing financial and market conditions can also affect results, for better or worse. In some cases, the situation can drag on for months or even years, during which the business of the stricken company may deteriorate. Investors in the event and event sector must be prepared to take a certain amount of risk, but also have patience.

Credit Based Hedge Fund Strategies

Most hedge funds lending strategies are based on capital-structure arbitrage, similar to event-oriented transactions. Managers look for opportunities in high-risk, low-return assets such as equities, bonds and derivatives.

Fixed Income Strategies for Hedge Funds

Hedge funds focus on loans, not interest, and many managers sell to hedge their interest-rate risk. Some trade in mortgage-backed securities such as mortgage bonds, credit default swaps and other derivatives, but many do not.

Hedge funds that engage in fixed-income arbitrage grind out returns from government bonds, eliminating credit risk.  These funds typically use a high leverage ratio to boost otherwise modest returns, but by definition leverage increases the risk of loss if the manager is wrong. If you expect long-term interest rates to rise compared to short-term interest rates, you will buy and sell in one market and then sell and buy in another.

Macro Hedge Fund Strategy

Some hedge funds analyze how macroeconomic trends will affect interest rates, currencies, commodities, or equities around the world, and take long or short positions in whichever asset class is most sensitive to their views. Managers often make big bets and their positions are somewhat personal sentiment. Many positions do not pan out although when they do the returns can be significant.

Quant Funds

A Quant fund is a hedge fund that uses statistical techniques, mathematical modeling, and automated algorithms, rather than fundamental analysis and human judgment, to make investment decisions and execute trades. Much has been written about Quant funds over the past few years and far from being complex the methodology behind a Quant fund is relatively straightforward.

A quant fund relies purely on statistical inference and mathematical modelling to predict the outcome of certain events on a stock price or commodity value. Quant funds use AI to analyse and model thousands of variances or outcomes to make accurate prediction. Quant hedge fund strategy is important as part of an overall hedge fund.