Top 10 Hedge Fund Investment Strategies
KEY POINTS
Hedge funds offer strategies ranging from directional to market neutral, global macro to event driven, and more
Sophisticated strategies demand complex models to process massive volumes of data and generate actionable trading signals
Perform your due diligence and you may find a hedge fund that fits the your unique risk tolerance and supports your short-term and long-term investment goals
Hedge funds have emerged as powerful investment alternatives that can generate substantial returns (positive and negative) while navigating global financial markets with reduced regulatory oversight.
The perceived high-risk high reward industry is derived from the broad array of investment strategies and technologies utilized by often opaque hedge fund managers.
Strategies are tailored to capitalize on very specific market conditions and opportunities. Each aimed at achieving superior risk adjusted returns.
We will review 10 of the most common strategies and highlight how they integrate into today’s financial landscape and global markets.
Top 10 Hedge Fund Investment Strategies
Long/Short Equity - Directional
This is likely the most well-known strategy. It aims to earn returns regardless of the overall market direction.
Long positions are taken in stocks expected to gain in value and short positions in stocks expected to fall in value. The portfolio usually has a net long equity exposure.
Short positions involve the manager selling stocks they do not own with the hopes of buying it back in the future at a lower price. To do this, the manager must borrow the stock from a financial institution, pay interest on such borrowings, and meet margin calls until the stock is repurchased and returned to the lender.
Short interest in a stock is one gauge of market sentiment. Short selling sometimes leads to a phenomenon known as a short squeeze.
A short squeeze occurs when a stock’s price increases and creates unrealized losses and increasingly higher margin calls for short sellers. Short sellers are eventually forced to capitulate and buy back the stock at higher than anticipated prices. Such purchases put upwards pressure on the stock price and intensify the short squeeze.
2. Long/Short Equity - Market Neutral
This strategy typically takes long and short equity positions in securities across multiple sectors with the goal of achieving positive returns while hedging away market risk.
Such differentiates itself from the long/short strategy which typically maintains market risk with a net long position.
Pair trading is an example of a market neutral strategy. Such a trade could involve two stocks with prices that historically move in tandem. If prices diverge from the historical pattern, the trader may go long the underperforming stock and short the overperforming stock. The manager will earn profits on both trades if the prices converge to their historical mean.
Market neutral strategies may hedge market risk, but they are not risk free. They are still exposed to sector specific risks, individual company risks, strategy execution risks, and more.
3. Global Macro
This strategy seeks to profit from macroeconomic trends and geopolitical events. The top-down approach will consider factors such as inflation, interest rates, exchange rates, central bank policies, international trade, and politics.
Macroeconomic analysis will identify opportunities based on perceived imbalances and policy changes. These opportunities will drive the decision to take positions in various assets including stocks, bonds, commodities, and currencies. Such trading is often executed efficiently through sophisticated trading systems and algorithms.
Leverage through short selling and derivatives are often utilized to implement the strategy. Such derivatives may include options, futures, swaps, and forwards.
The nature of the strategy has an inherently high degree of market risk. Risk management may include hedging strategies, diversification, position sizing, and stop-losses.
4. Event Driven - Merger Arbitrage
This strategy seeks to profit from the completion of a merger or acquisition by simultaneously buying and selling securities of the companies involved.
The acquiring company typically offers a premium to the target company’s share price. Therefore, the fund manager may sell (short) shares of the acquiring company and buy (long) shares of the target company.
Hedge fund managers typically utilize two strategies for merger arbitrage.
First, implement the trading strategy before a merger or acquisition announcement is publicly made. Such is highly speculative and involves identifying opportunities through research of public announcements, regulatory filings, industry news, and other sources. No amount of research can guarantee the anticipated merger or acquisition will ever be announced.
Second, implement the trading strategy after the merger or acquisition has been publicly announced. The manager must evaluate the likelihood of the deal’s completion. The likelihood can be impacted by many evolving variables including financial disclosures, regulatory requirements, political influence, shareholder votes, legal challenges, and the timeline constraints.
5. Event Driven - Distressed Securities
This strategy seeks to profit from distressed companies that are facing financial difficulties.
Managers seek to profit from special events that may include debt restructuring, bankruptcy, liquidations, mergers and acquisitions, litigation outcomes (e.g., class-action lawsuits), regulatory changes, and more.
They will research and purchase stocks and debt securities at a discounted price when the company is in financial distress. Their research and financial models anticipate the potential to profit from a future positive outcome that may include a debt restructuring, a return to profitability, or the resolution of regulatory / legal hurdles.
6. Event Driven - Convertible Arbitrage
This strategy seeks to profit from price inefficiencies related to convertible securities that are caused by corporate events or market forces.
A convertible security is a financial instrument (e.g., preferred shares) that can be converted into another type of security of the same issuer (e.g., common shares).
Corporate events that may impact the pricing of convertible security include mergers, acquisitions, dividend announcements, stock buybacks, spin-offs, restructuring, and more.
A corporate event may create temporary pricing inefficiencies (i.e., arbitrage opportunities) between the convertible security and the underlying common stock. Managers must model a set of complex variables that may include conversion premiums, implied volatility, credit quality, potential timing of the event, and more.
7. Event Driven - Activist Investing
An activist investor typically takes a significant minority stake in a company with the aim of initiating change and unlocking value for shareholders.
They may demand a seat on the board of directors and changes in strategic direction and/or management. Such may involve mergers, acquisitions, divestitures, restructuring, and corporate governance reforms.
Hedge fund managers may take a direct activist role in a company.
Or they may research and identify companies that may be the targets of other activist investors. The ability to identify such companies and predict their outcome will dictate the hedge fund manager’s investment strategy.
8. Managed Futures
This trading strategy involves trading futures contracts across multiple asset classes including commodities, currencies, interest rates, and equity indices. Such contracts can be traded long or short to profit from market movements in specific markets.
Futures involve a high degree of leverage as they are based on margin. The leverage will amplify gains and losses. The margin balance supports a proportionately large notional value. Changes in the notional value can lead to substantial margin calls and potential cash management issues.
Two common trading approaches are trend following and systematic. Trend following may be based on moving averages, trendlines, and momentum indicators. Systematic trading is based on predefined rules and algorithms.
9. Algorithmic / Quantitative
This strategy is dependent upon the development of mathematical models and algorithms that process vast amounts of data and produce proprietary trading signals.
The data may be derived from pricing sources (e.g., Bloomberg, Reuters), news feeds, and economic indicators. The data processing requires the data to be normalized by removing all errors, anomalies, and inconsistencies.
The model must generate trading signals based on multiple factors including historical data, market conditions, portfolio constraints, and more.
10. Multi-Strategy
Some hedge fund managers will operate a multi-strategy fund that will involve more than one of the strategies above. The manager may oscillate between strategies depending on the perceived opportunities in the market at a given point in time.
Multiple strategies may provide a higher degree of diversification and the potential for higher risk-adjusted returns. However, they also demand a diverse skill set within the investment team that may increase risk.
BOTTOM LINE
Hedge funds have a wide range of strategies to choose from. The ultimate success is contingent on the manager’s expertise, technology, market conditions, changing market regulations, volatility, risk management, and so much more.
We recommend that you work with your financial advisor to perform appropriate due diligence prior to adding hedge funds to your investment portfolio.
