Hedge Fund Strategies

Hedge Fund Strategies. The choice of hedge fund strategy dramatically affects your risk/reward ratio. Which are the main strategies used by hedge funds?

Mutual funds and hedge funds differ significantly in their investment approaches. While mutual funds primarily invest in equities and bonds that managers believe will increase in price, hedge fund managers employ a broad variety of tactics to leverage existing opportunities or to take advantage of new opportunities. Here are the main hedge fund investment strategies:

Directional/Tactical Hedge Fund Investment Strategy

Typical tactical or directional hedge fund investment strategies include the following:

  • Managed Futures – The hedge fund manager invests in commodities with a momentum focus and hope to ride the trend to attractive profits.
  • Long/Short equities – Established by Alfred Jones, this strategy involves going long on equities managers believe will increase in value and going short on equities managers believe will decrease in value. A two-dimensional bet (going both long and short on different equities) increases the returns but also increases the risks.
  • Macro-Centric – The hedge fund manager invests in securities which allow him to profit from changes in markets that are attributed to government and business influence and intervention. Broad-based investments include playing FX movements or investing in market indices. This is the high risk ‘top-down’ investment approach.
  • Market Timing – With this strategy, hedge fund managers attempt to time the entry and exit points, and attempt to forecast the future market direction.
  • Emerging markets – Hedge fund managers will invest with a special focus on emerging markets, as these markets generally offer high growth prospects. However, they are also volatile and subject to fluctuating inflation.

Arbitrage/Relative Value Hedge Fund Investment Strategy

Arbitrage investments are generally low-risk, since they take advantage of short-term market inefficiencies that will most likely be eliminated eventually. Hedge fund strategies that take advantage of arbitrage include the following:

  • Convertible arbitrage – Hedge fund managers take advantage of perceived price inequalities that offers low-risk profit opportunities. This works on the assumption that prices will eventually return to a neutral position. Thus, managers may go long on a bond while going short on the equity stock to take advantage of the spread inequality.
  • Equity market neutral – With this strategy, hedge fund managers often use leverage to buy an equity and sell short the related index in order to offset the systematic market risk. This is a way to hedge securities, and capitalizes on the perceived growth prospects of the equity security while minimizing the risk of the market from driving down the price. This is a low risk strategy that can be very profitable.
  • Fixed-Income arbitrage – Hedge fund managers will go long and short on different fixed-income securities in order to minimize market risk.

Event-driven Hedge Fund Strategy

Event driven investment approaches generally carry a moderate risk. Some of the most common strategies used by hedge funds include the following.

  • Distressed securities – With this fund strategy, hedge fund managers look out for companies in or facing bankruptcy. They then invest in these companies at steep discounts to estimated values; these discounts offer opportunities for profit. However, the major risk here is the risk of default.
  • Reasonable value – With this fund strategy, hedge fund managers invest in securities selling at discounts to perceived value as a result of being relatively unknown or out of favor for particular reasons in the investment community. With this strategy, managers invest in equities with lower risks of default.
  • Merger arbitrage – With this strategy, fund managers invest in unique opportunities for profit driven by corporate action. Examples include mergers and leveraged buyouts, corporate takeovers, legal reorganizations. Managers attempt to capture the market price spread between the companies involved in mergers or takeovers.
  • One-time offs – This opportunistic investment strategy focuses on identifying specific events that offer short-term profit opportunities. These are one-time off, but offer the potential of high returns.

The hedge fund strategies here are the most important ones that hedge fund managers typically use. More on Hedge Fund Manager Compensation and Types of Hedge Funds.

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