Overview of Hedge Fund Strategies

Introduction

Hedge funds represent an important subgroup of alternative investment opportunities.

Key features that distinguish hedge funds from traditional investments include:

Lower regulatory and legal constraints.

Flexibility to use short selling and derivatives.

A larger investment universe.

Aggressive investment exposures.

Comparatively free use of leverage.

Liquidity constraints for investors.

Lack of transparency.

Higher cost structures.

The key question is whether the high expense levels of hedge funds are justified by the return and diversification benefits that hedge funds are intended to deliver.

Some asset managers seek out hedge funds as a source of alpha, which tends to be elusive. Others view hedge funds as a way to access top investing talent.

Classifications of Hedge Fund Strategies

Hedge fund strategies are categorized based on the kinds of securities they invest in, the trading approach they use, and the kinds of risk exposures taken.

There are numerous ways to classify hedge funds, but in this topic review, we use the following six strategy categories:

1. Equity related. These fund strategies focus on stocks, and hence the primary source of risk is equity risk. There are several subtypes, including long/short equity, dedicated short bias, and equity market neutral.

2. Event driven. These strategies relate to corporate actions such as governance activities, mergers, acquisitions, bankruptcies, and other major business events. The main dangers of these strategies are event risks, the possibility that outcomes will not unfold as expected (examples include: the failure of a merger, credit downgrades, or bankruptcy).

In the following LOSs, the event driven hedge fund strategies that we will examine are merger arbitrage and distressed securities.

3. Relative value. These hedge fund strategies seek to profit from the price differentials between related securities. For debt securities, the valuation differences being exploited span securities with different credit quality or liquidity.

Two relative value strategies that will be considered further are fixed income arbitrage and convertible bond arbitrage.

4. Opportunistic. These strategies employ a top down approach, often span multiple asset classes, and vary with market conditions. The two opportunistic strategies that will be considered here are global macro and managed futures.

5. Specialist. These strategies generally require specialized market expertise or knowledge. Often the risks of these strategies arise due to exposure to specific sectors or unusual securities.

The two such specialist strategies we will consider in this topic review are volatility strategies and reinsurance strategies.

6. Multi manager. These strategies use other hedge fund strategies as building blocks, combining different strategies together and rebalancing exposures over time. The two types of multi manager hedge funds we will consider are multi strategy funds and funds of funds.