Hedge funds apply various strategies, and every fund manager can always claim that his strategy is unique and can’t be compared with others.
However, many of these strategies can be grouped into certain categories. This helps analysts and investors to assess a manager’s skills and understand which result can be achieved using a certain strategy under specific macroeconomic conditions.
The following list is quite an unrestricted one and doesn’t include all the hedge fund strategies; however, it can help a reader to get an idea of how diverse and complicated the existing approaches are.
Stock market hedging. Commonly, a fund is believed to use this strategy when it combines long and short positions in stock trading. It is one of the cognitively simplest strategies; however, it can be applied in a variety of forms:
Within this strategy, hedge fund managers either buy stocks that they believe to be undervalued or sell short, getting rid of stocks that they think to be overvalued. In most cases, for a fund using this strategy the market risk exposure will be positive.
For instance, if 71% of a fund’s assets are invested in long positions and another 29% in short ones, the net risk exposure will be 40% (71-29%). Another method should be used to calculate the gross risk exposure, which amounts to 100% – this means that a fund doesn’t use credit leveraging.
If a manager increases investment in long positions, let’s say up to 81%, at the same time maintaining short positions, the gross risk exposure will amount to 111% (81% + 29% = 110%), which indicates a credit leveraging of 10%.
Within this strategy, a hedge fund manager applies the same principles as in the previous option, but aims at minimizing risk exposure on the market in general.
There are two ways to do it.
If one invests equal fund shares in long and short positions, the net risk exposure will amount to zero. For example, if 49% of funds are invested in long positions and another 51% in short ones, the net risk exposure will be 0% and the gross exposure will amount to 100%.
There is a second method to make investments market neutral: to form a beta-neutral portfolio. In this case, a fund manager will estimate his long and short investments so that the total portfolio beta coefficient is as low as possible. Anyhow, a manager tries to eliminate influence of market fluctuations completely so that all the probable growth depends only on his skills to choose stocks to purchase.
Both of these strategies can be used within a certain region, sector or industry; they can be applied for investing in stocks with certain market capitalization, etc.
In the world of hedge funds, everyone does his best to stand out, and you can easily notice the ins and outs in approaches of every particular organization; however, all of them rely on the same basic above-mentioned principles.
This group of strategies is characterized by the highest risk/profit ratio among all the hedge fund strategies.
Funds that apply this strategy invest in stocks, bonds, currencies, commodities, options, futures and other types of derivatives.
It’s a general practice that in this case, investment volume is determined by the cost of a company’s basic assets and is usually to a large extent financed from the borrowed funds.
Majority of these funds operate on the global markets and due to the broad scale of their investments and markets they invest to, they manage to achieve considerable growth without facing financing problems.
However, many funds, whose history ended with huge failures, used this very strategy, including Long-Term Capital Management and Amaranth Advisors. Both of these funds were quite large-scale ones and both applied a high share of borrowed funds.
This name covers lots of different strategies that are suitable for various types of securities.
The key idea is that a hedge fund manager purchases a security whose price he believes to rise and at the same time, he opens a short position on a linked security that can drop in price.
“Linked securities” term can imply stocks and bonds of a certain company, stocks of two different companies of the same sector, or two bonds of the same company with different dates of maturity and/or coupon rate.
In every case, there is a kind of the equilibrium value that can be calculated easily by looking at differences between the linked securities.
Let’s suppose, a company has two outstanding bonds: the coupon yield of the first one is 8%, and of the second one is 6%. Both have the absolute priority for the company assets and both will be paid off simultaneously.
Since the coupon yield of the first bond is higher, it should be sold with a premium to the second bond’s price. If the bond with 6% is traded at nominal value ($1,000), the second bond should be traded at $1,276.76, other things being equal.
However, the premium size is often upward or downward different from the optimal one, and a hedge fund can take advantage of this temporary price difference.
Let’s suppose that bonds with 8% are traded at $1,100 and bonds with 6% still cost $1,000.
To take advantage of this price discrepancy, a hedge fund manager should buy bonds with 8% and open a short position for the bond with 6%.
For illustration purposes, we used quite a large price spread; however, in real practice it may be much smaller. And to gain substantial profit, hedge funds have to use leverage.
The most effective type of such arbitration in recent times is an inter-exchange spread based cryptocurrency arbitrage
This is a type of arbitrage based on relative value.
Some hedge funds just invest in convertible bonds; however, a hedge fund that applies this strategy simultaneously opens positions for convertible bonds and stocks of the same company.
A convertible bond can be exchanged for a certain number of stocks. Let’s suppose that a convertible bond is traded at a price of $1,000 and can be converted into 20 stocks. This means the stock market price amounts to $50.
A hedge fund manager that applies convertible arbitrage purchases convertible bonds and opens a short position for stocks, hoping that the bond price will rise and the stock’s cost will decrease.
Keep in mind that there are two factors that affect a convertible bond price stronger than a stock price:
Therefore, even if the stocks and bonds prices are at equilibrium, a hedge fund manager may use convertible arbitrage if he believes that implied volatility of the bond option part is too low or that the interest rate decrease will have a stronger impact on the bond rate than on the company’s stock price.
Even if he makes a mistake and it will turn out to happen just the other way about, his risk exposure will be low, since the position is safe from the influence of any news about the certain company.
Thus, a manager using convertible arbitrage should open a large number of positions, with each of them generating a relatively moderate income for him. However, the total amount of risk-adjusted profit will be quite attractive.
Again, just as in case of using other strategies, it encourages a manager to use borrowed funds to increase profits.
Hedge funds that invest in distressed securities are really unique ones.
Quite often, these hedge funds take active part in debt restructuring of such companies and may even hold positions in the board of directors to help them return to growth.
It doesn’t mean that all the hedge funds using this strategy do it. Many of them purchase these securities, hoping that growth will be triggered by general market trends or current management’s strategic plans.
One way or another, this strategy involves purchasing bonds that have fallen in price due to the company’s financial instability or anxious investors who believe that the company is in a terrible condition.
In other cases, a hedge fund may purchase cheap stocks of companies recovering from bankruptcy, believing that their position should improve soon. It is a dangerous strategy, since many companies still fail to reverse the situation for the better. However, distressed securities are so cheap that risk-adjusted profits can be extremely attractive.
There are numerous hedge fund strategies that are omitted in this article.
Even the above-mentioned strategies have been described in an extremely simple way and can be much more complicated than they seem. Moreover, many hedge funds use more than one strategy, assessing the currently available market possibilities and reallocating their assets accordingly.
Each of the above-listed strategies can be assessed on the basis of probable absolute returns, depending on the macro and microeconomic situation, the factors adherent to a particular sector, and even on the government and regulatory authorities’ policy.
This very assessment is the most important factor when deciding on the funds allocation. It makes it possible to determine the right moment to make investments and the expected risk/profit ratio for each strategy.
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