Hedge fund strategies and jargon
Main hedge fund strategies
Hedge funds come in an incredibly diverse array of strategies and approaches. We’ve summarised key points about some of the main strategies here:
- Arbitrage funds look to benefit from mispricings of the same instrument/asset or extremely closely related instrument.
- The strategy covers the following areas: convertible bond arbitrage, tail protection, volatility or opportunistic trades in this area.
- This is expressed through capital structure arbitrage, ETF arbitrage or arbitrage of other closely related instruments.
- Analogous to equity long/short, except that portfolio managers focus on the credit (bond) instruments of the underlying companies.
- Managers will take long positions in firms which they believe are positioned for increasing corporate financial health and short positions in firms which they believe will face financial or earnings pressure in the future.
- More exotic credit strategies can also include mortgage-backed securities and capital structure strategies which employ a relative value approach between two or more bonds of the same company.
- Long/short equity funds invest in equities that are expected to increase in value and sell short equities that are expected to fall, or use indexes to hedge market risk.
- Most are benchmark agnostic, not needing to invest in large-cap stocks that they believe offer little value.
- The main difference between long/short equity and traditional long-only is the ability to take short positions and use leverage. Long/short funds also tend to be more concentrated than their traditional counterparts.
- Can follow a single PM or platform structure.
- Typical net market exposure is 40-70%.
- Event driven is a broad strategy category covering funds that invest in securities of companies facing announced and anticipated corporate events.
- This includes, but is not limited to: M&A, spin-offs, company restructurings, and some distressed situations (although if this is the dominating part of the strategy it will be classified as ‘credit-distressed’).
- The strategy identifies mispriced securities with favourable risk/reward characteristics based upon differentiated views of value-unlocking catalysts, event-probabilities, and post-event valuations.
- Long only or overwhelmingly long-biased strategies.
- Covers multiple asset classes, such as: equities, fixed income, and commodities.
- Global macro portfolio managers have a wide range of tools at their disposal, including stocks, bonds and currencies. They seek to generate gains from identifying medium-term themes drive by economic and political change.
- Derivatives are often used to reduce unwanted risk, and create asymmetric payoff profiles.
- Positions tend to be thematic in nature, backed by rigorous economic research and political insight.
- Managers can also take a more short-term approach and trade around data releases, as well as global and local events (e.g. elections) which may affect markets.
- A hedge fund where the capital is deployed across multiple sub-strategies and asset classes. Funds are typically extremely diversified and employ multiple PMs/risk taking groups.
- Covers a range of strategies that are all researched, developed and traded using quantitative methods. Involves the use of computer algorithms, automated execution systems and vast amounts of data.
- Statistical Arbitrage: Uses quantitative computer models (algorithms) to exploit differences in stock prices by being both long and short in stocks which have historically exhibited repeatable behavioural tendencies.
- CTA/Managed Futures: Look to benefit from medium- and long-term trend-following. Takes long or short positions across equity, fixed income, FX and commodities futures. Can also incorporate relative value or short-term reversion strategies.
Hedge funds use a lot of esoteric language. We’ve given brief definitions here to some of the key terms we’ve used that will help you to understand what a hedge fund is and how they operate.
Alpha is a measure of manager skill, it is the return a hedge fund makes over the return of the market as a whole.
Arbitrage is a way of exploiting small price differences in the same or similar securities across multiple markets, by purchasing it in the cheaper market and immediately selling it in the more expensive market. It is a lower-risk hedge fund investment strategy.
Beta measures the systematic risk of a hedge fund portfolio to the market as a whole, i.e. how much wider market moves have historically impacted the portfolio.
A derivative is a financial instrument (e.g. an option, a future, a swap, a warrant, a forward contract) structured as a bilateral contract, or an exchange traded, listed derivative, where the value is based upon an agreed upon asset (e.g. an interest rate, a stock, a physical commodity etc.).
Directional hedge funds are those that don’t hedge away their risk, they keep exposure to a market and try to get higher returns for the risk they engage in.
Where hedge funds borrow money, typically to amplify returns. This will, however, also increase the scale of potential losses if they happen. There are many ways to employ leverage, e.g. by using derivatives like options and futures, or using margin accounts, physically borrowing from other counterparties or via repurchase agreements (repos).
A market neutral hedge fund mitigates market risk by having limited beta to the market. It does this by pairing long and short investments. By being market neutral it seeks to generate positive returns regardless of whether the overall market is going up or down.
Net and gross exposure
Gross exposure is the sum of a hedge fund’s long and short positions, usually expressed as a percentage i.e. if a fund is 70% long and 30% short = 100% gross exposure
Net exposure is the difference between a hedge fund’s long and short positions, usually expressed as a percentage i.e. if a fund is 70% long and 30% short = 40% net exposure.
Platform funds are multi-manager funds where there are many teams of traders that operate autonomously. They have stringent risk parameters, and are limited in the magnitude of losses (drawdowns) they can experience before remedial action from the fund’s management. Leverage is employed at the overall platform level, rather than at the individual trader level.
Portfolio manager (“PM”)
Portfolio managers are responsible for designing the investment strategy of a hedge fund and for the implementation of that strategy. They manage the risk of the portfolio and make final trading decisions.
A relative value hedge fund strategy seeks to exploit differences in the prices of related securities.
Single vs multi-manager funds
A single manager hedge fund is run by a single portfolio manager, whereas a multi-manager fund has multiple PMs. As a result, multi-manager funds tend to invest in more varied sectors and diversified instruments.