Last Updated: February 2, 2023
Hedge fund strategies differ in many ways, but they all use the same hedge-your-bets principle. This article delves into various hedge fund investing strategies that institutional investors and fund managers use. We also walk you through the pros and cons of investing in hedge funds to help you decide if it’s a good investment choice for you.
What Are Hedge Funds?
A hedge fund is an investment fund where investors and partners pool their money and invest in a wide variety of financial instruments. Unlike traditional mutual funds, hedge funds are more flexible and often riskier. As a result, such funds are usually exclusive to well-off investors who can tolerate the risk. Hedge funds often incorporate as a limited liability company (LLC) or a limited liability partnership. If you plan to put up a hedge fund, the most reliable LLC services can help you.
To understand how hedge funds work, think of the parties involved as partners—the fund manager is the general partner, and the investors are the limited partners. Together, they pool their resources and aggressively invest in a wide array of securities. They agree on an investment strategy and use it to earn returns. To amplify their returns, hedge funds often use leverage or borrowed money. They also take aggressive short positions.
|NOTE: After launching in the 1990s, hedge funds have grown substantially. The total assets under management value are over $3.25 trillion, according to a 2019 report.
Type of Hedge Funds
Hedge funds can be categorized by how they issue shares and what financial assets they invest in. The following are the most common types of hedge funds.
Open-Ended Hedge Funds
Open-ended funds issue unlimited shares, which are sold and bought on demand. Investors can buy or sell shares at their net asset value (NAV) determined at the end of each trading day.
Closed-Ended Hedge Funds
Closed-ended funds issue a fixed amount of shares on an exchange or over-the-counter (OTC). Unlike other types of hedge funds, they don’t trade on their NAV. Instead, share prices depend on the supply and demand for their funds, along with other fundamental factors.
Macro Hedge Funds
Macro hedge funds invest in the stock, bond, and forex market intending to earn returns via the changes in global macro and economic trends. Examples of fund-driving events include monetary policy changes and international interest rates.
Equity Hedge Funds
Unlike a macro fund, an event-driven hedge fund, equity hedge funds focus on high-performing stocks. The fund can be country-specific or global. While investing in growth stocks, the fund also hedges its bets by shorting weak-performing stocks.
Relative-Value Hedge Funds
These funds take advantage of temporary price inaccuracies among related securities.
Different types of hedge funds use a variety of investment strategies to maximize returns. Other hedge fund types include aggressive growth funds, income funds, emerging market funds, and value funds. Alternatively, think about investing in cryptocurrency.
|NOTE: To attain more stable investment returns, some hedge fund investors invest in the so-called ‘fund of funds’ (FOFs), which mix and match several hedge funds and pooled investments.
Hedge Fund Investing Strategies
The following seven strategies are the most popular among savvy investors. But remember that each of these has its own set of benefits and risks.
Global Macro Strategies
Global macro strategies center around the overall macroeconomic trends and political views of countries. Accordingly, these funds base their projections on large-scale, international events around such factors as:
- Interest rates
- Domestic and foreign policies and relationships
- Exchange rates
- International trade
The global macro strategy is among the most flexible types of hedge fund strategies. Portfolios can be invested in different assets, such as stocks, bonds, currencies, commodities, and futures (both long and short). So, for example, if fund managers deem a specific country heading for growth, they may decide to go long on that country’s assets. Meanwhile, they may also be going long on another country’s assets.
Long/Short Equity Strategy
Long/short equity strategies are a two-pronged approach to investment. On the one hand, you go long in stocks that you expect to go up. On the other hand, you go short in stocks that you expect to decline. This strategy aims to profit on both the market climb and market decline.
Long/short hedge fund strategies have a bias to the long side, which means they invest more in stocks expected to grow. Usually, the ratio is 130:30, where 130% of assets under management are invested in long positions, while 30% is invested in shorted stocks.
Arbitrage strategies center around exploiting price differences between closely related assets by buying and selling them simultaneously. Three of the most popular arbitrage strategies among investors include:
Merger Arbitrage Hedge Funds
These funds involve buying and selling the stocks of two merging companies. The stock price of the target company typically sells below the acquisition price. As a result, these funds predict whether the merger will happen on time.
Fixed Income Arbitrage
This investment strategy involves taking opposing positions in inefficiently priced fixed-income securities, such as bonds and their derivatives. This approach exploits the price difference between assets by buying them on one market and selling them on another. Fixed-income hedge funds also employ a subset of more complex arbitrage strategies, such as swap-spread arbitrage, yield curve arbitrage, and more.
Stocks can be categorized into common and convertible (or preferred) stocks. Convertible arbitrage entails taking opposing positions of each of those stocks. Typically, hedge funds take long positions of the company’s convertible securities and simultaneously take a short position of their common stock to take advantage of price discrepancies in the company’s stocks. But as with many arbitrage hedge funds, proper execution is essential; a single mistake can cost outsized losses.
Relative Value Arbitrage
This strategy (also called ‘pairs trading’) exploits price discrepancies between highly correlated investments, which are ones that often move in the same director. When an asset goes up, a highly correlated asset also moves up—examples include stocks in the same industry.
Capital Structure Strategies
This strategy is similar to arbitrage strategies. It aims to exploit price inconsistencies among assets, with the difference being that it’s focused on the relative mispricing across the same company’s differing assets. This hedge fund strategy centers around equity- and debt-linked assets.
For instance, a lower-than-expected earnings report may trigger a sharp market decline in the company’s stock, usually directly after the announcement. The price reduction, however, may not be immediately reflected in the bond market because it has different participants and dynamics. If it is reflected, the decline may not be as sharp as in the equity market. This capital structure arbitrage is an opportunity for hedge funds to move and cash in such price discrepancies because of the company’s structure.
Event-driven strategies aim to exploit temporary price discrepancies before or after corporate transactions, including mergers and acquisitions, spinoffs, takeovers, and bankruptcy. During these events, the stock of the companies involved usually suffers. This strategy has multiple executions, but expertise is necessary to understand how to exploit price inconsistencies. Perhaps, you can hire a registered agent if you need some advice.
To successfully execute event-driven strategies, you must be patient and willing to take risks. Corporate transactions don’t often happen according to plan, and you must be adaptable. Other times, hedge funds throw different strategies into the mix to offset risks, such as what a convertible arbitrage hedge fund might do.
A multi-strategy approach utilizes multiple strategies—the main goal is to deliver positive returns regardless of where equities, currencies, or other markets are moving. This technique centers on diversification, i.e., not putting all your eggs in one basket. Instead, fund managers shift risks around to reduce the overall chances that the fund faces.
Apart from reducing risks, a multi-strategy hedge fund also looks for the best opportunities to maximize returns. During periods of fast growth, these funds further diversify into more profitable assets. These funds employ the best-in-class experts who have the skillset to mix and match strategies that benefit the portfolio overall.
Market-neutral strategies aim to have zero net market exposure, meaning that its long and short positions are equal. This strategy is the less risky version of a long-short equity hedge fund approach in that it doesn’t have a bias on the market climb. The drawback is that while risks are lower, the fund’s expected returns are also much lower.
Market-neutral strategies rely on deliberate stock selection and reducing risks. As a result, market-neutral hedge funds have the lowest correlation to the market because they hedge away from general market risks and depend on the price convergence of specific stock picks.
|NOTE: Apart from stocks, interest rates and fixed-income assets are heavily traded under capital structure arbitrage. When hedge funds trade interest rates using this strategy, it turns into a credit hedge fund.
|Hedge funds are a popular investment vehicle that pools assets and use more flexible and riskier strategies to earn returns from the market.
|You can categorize hedge funds based on their pricing process and strategies used by fund managers, such as open- and close-ended hedge funds.
|The most common hedge fund strategies use arbitrage, which aims to exploit price inconsistencies by taking opposing positions and earn returns.
|The most popular strategies that hedge fund investors use are global macro, long/short equity, capital structure, multi-strategy, and market-neutral strategies.
Pros and Cons of Investing in Hedge Funds
Like many other investments, investing in hedge funds has good and bad sides. Here are some pros and cons of hedge fund investments:
- Hedge fund investments are flexible. You can use them in strategies, such as short selling, derivatives, and high amounts of leverage. Unlike traditional mutual funds, hedge funds aren’t heavily regulated, making them open to more non-conventional types of investing.
- Hedge funds are popular for their aggressive growth and returns. Fund managers use strategies that try to minimize risk and bolster earnings.
- This investment fund is diversified, which is a must-do when investing. Hedge funds give you instant diversification, as they invest in multiple assets across various markets.
- To execute hedge fund investing strategies, a fund manager must be financially savvy and expert. Funds hire such individuals to manage their portfolios and money. Also, it’s wise to have online legal help just to be safe.
- Hedge funds have high fees, with a ‘2 and 20’ fee structure—investors pay a 2% management fee for the fund’s operation. Then, they pay another 20% to the fund manager for profits made over the year.
- To earn high, hedge funds take outsized risks. The strategies they use aren’t always accurate, and the high amount of leverage they use amplifies any losses incurred due to mistakes.
- Hedge funds are exclusive—the investment strategies of hedge funds tend to favor those with a high amount of capital to spare. And the risks are higher. As a result, hedge funds tend to be exclusive to accredited individuals who can shoulder such risks.
Hedge funds are a popular investment vehicle where investors pool their money and invest in various assets and securities. These funds are both highly flexible and risky in that they use non-conventional trading strategies while shouldering outsized risks. Hedge fund strategies emphasize hedging the fund’s bets, using arbitrage as a common way to offset risks while maximizing returns. Overall, hedge funds offer higher earnings that come with higher risks.
Hedge funders invest the pooled investments across various asset classes using non-traditional strategies. As a result, they spend more to gain more—they pursue aggressive investing strategies and higher returns while carrying more risks than ordinary investors. Correspondingly, hedge funders often consist of wealthy institutional investors.
Hedge funds invest in non-traditional assets or anything that has value, such as land, real estate, currencies, and others. Their strategies enable them to also jump across asset classes—typically highly correlated ones that move in synchrony with each other. They also tend to use arbitrage to offset risks.
Hedge funds trade in different ways. With open-ended funds, traders trade fund shares using their net asset value calculated at the end of the trading day. Limited shares can be traded with a close-ended fund. Hedge fund strategies also dictate how much or how frequent a hedge fund investor can trade.