What are the “Hedge Fund Strategies”?
Hedge funds are alternative investments that are famous for applying sophisticated strategies in order to achieve higher returns. Unlike mutual funds, they are not as heavily regulated and therefore can utilize a much larger opportunity set and invest across various asset classes and instruments. Most of them are relatively illiquid and would require a lock-up or periods with limited withdrawals. Often, the higher potential returns come at the expense of using a higher risk and therefore it is important for hedge funds investors (institutions, high-net-worth individuals or other corporates) to understand the strategy behind these investments.
Key Learning Points
- Hedge funds have vast flexibility in terms of investment opportunities and approaches that they can use to generate high potential returns.
- This is because they are less regulated (some even abide by no regulation) relative to mutual funds and therefore have a larger investment opportunity set.
- Hedge funds are aiming at achieving high returns regardless of the prevailing market conditions.
- Although it is difficult to construct a particular peer group because of their versatile nature, hedge funds mainly use a couple of strategies that could serve as a guide to investors.
- Some of the tools available to hedge fund managers are gearing (or leverage), short selling and derivatives.
This is an approach where hedge funds managers construct and run their portfolios considering global macroeconomic trends. These can include interest rates, inflation, currencies and economic cycles etc. To achieve optimal returns, managers would normally trade in various asset classes and products such as currencies, derivatives (mostly futures and options), commodities, equities and bonds.
As its name suggests, event-driven strategies rely on the possible outcome that could occur following a particular event. These opportunities are often related to corporate transactions such as mergers, acquisitions, liquidations or bankruptcy. To gain exposure to such companies, portfolio managers run their portfolio as a basket of distressed securities or special situations, where the market undervalues the fundamentals of a company and a structural or corporate change is anticipated.
In this type of strategy, the manager would usually make long and short bets on companies from the same industry. These are known as “pair trades”. For example, taking a position in Royal Dutch Shell and shorting (betting that the company’s share price will decline) BP is a pair trade and is expected to produce a positive outcome regardless of the market environment as long as Shell outperforms BP. This is because the manager is taking a more stock-specific risk, which reduces the overall market risk.
Relative Value Arbitrage
Taking advantage of relative price discrepancies between different securities is the main philosophy of relative value arbitrage strategies. The manager would position the portfolio in line with his/her expectations for prices to diverge or converge over time. Sub-strategies could include fixed income arbitrage or convertible arbitrage, in which the portfolio is usually long on convertible bonds and short on a proportion of the shares into which they can convert. This type of strategy is very efficient in a higher-risk environment where higher volatility creates more opportunities for the manager to crystalize profits.