Hedge Fund Strategies

What Are Hedge Fund Strategies?

Hedge fund strategies are a collection of techniques that a hedge fund implements to safeguard the investment fund against market fluctuations in stocks or securities.

The aim is to maximize returns and generate an alpha without putting the entire budget in danger.

Hedge funds are utilized by wealthy (high-net-worth individuals) candidates because investing in them can be quite risky. Some firms require a minimum investment or net worth to begin investing. They also require higher fees for the amount earned. 

In general, hedge funds collect money from investors. They will invest their money into strong investments, and then they will hedge said investments. They will take two investments, going in opposite directions; one is the primary investment the other is the hedge.

Other funds, such as equity and activist funds, involve a large amount of risk and use investment strategies by investing in many different assets ranging from debt and equity investments to commodities, currencies, derivatives, and real estate. 

Hedge funds can create excellent, rewarding strategies because they employ diverse investment and hedging techniques that aim to generate exceptional returns and alpha regardless of market movements.

Hedge funds are generally not regulated by the Securities Exchange Commission (SEC); instead, they are regulated by the Commodity Futures Trading Commission (CFTC), which also includes advisers registered as Commodity Pool Operators (CPO) and Commodity Traders' Advisors (CTA).

However, many funds do not have liquid funds, and the investor will have to leave the money in for a long time.  

There are numerous tactics that can be followed while making an investing decision. It employs both basic and quantitative methodology. Depending on the industry, this hedge fund approach may be broadly diversified or specifically focused.

Understanding Hedge Fund Strategies

Hedge fund strategies are understood as a set of principles and guidelines implemented by hedge fund managers to safeguard themselves from stock and other derivatives movements.

Hedge funds use non-traditional strategies. For example, they are not liquid like a mutual fund, and many investment funds require an investor's capital to be invested for many years. This allows them to gain the best possible investment for their stakeholders. 

Hedge funds are considered risky, which is why most funds have a minimum investment or net worth threshold for investors. The money is pooled into a few primary accounts and then pushed into investments, and it will likely incur losses at some point.

Their investments can be very versatile; for example, they can use tools such as leverage, derivatives, shorting or going long in stocks, and private equity. The Investment funds will use a combination of these investment tools to create high returns with the least risk.

Although these institutions are considered to be high-risk by some individuals or firms, investors may use their expertise to avoid the market's volatility and considerable downturns. These firms can withstand market corrections or declines better than other investment vehicles. 

Most of the strategies used by hedge funds will limit their downside risk. Moreover, most strategies will bet in both directions allowing them to make up for the losses created. The short positions they make will make up for the losses in long positions, and vice versa. 

Different Hedge Fund Strategies and How do they work? 

Hedge fund strategies do produce some extraordinary results and compounded annual rates. However, these strategies should be applied diligently and accurately to reap the benefits that we aim for.

Making an investment decision is not as simple as it seems. A wide range of quantitative and fundamental techniques are used by hedge fund managers.

All of these strategies can be considered common by hedge funds. With most of these strategies, there will be a long and short position to hedge. Some of the most common examples of hedge fund strategies can be seen below:

• Long/Short
• Merger Arbitrage 
• Convertible Arbitrage 
• Capital Structure Arbitrage 
• Fixed-Income Arbitrage 

Long/Short 

The long/short hedge fund strategy is the strategy to take both long and short positions on specific stocks/derivatives to achieve positive returns. Investors buy the stocks they believe will increase in value in the future (long position) and sell the stocks they believe will decrease in value in the future (short position).

The technique is utilized to benefit from the outperformance of the long-positioned stock to short-positioned stock.

This strategy was used by the first hedge fund created in 1949 by Alfred W. Jones. This is the most simple strategy used by funds because it involves taking a long or short position in one stock and hedging by taking a short or long position in the other.

Since this strategy is original and simple, most funds today use it. It can be very profitable while reducing or eliminating losses from the position.

Example

For example, if an investment fund's stock analyst believes Tesla Inc. (TSLA) has a strong buy signal, then the fund manager can decide to take a long position in Tesla. Next, they can open a short position to counteract their long position and reduce losses if Tesla's stock price declines. 

Suppose Tesla will increase by 5% in the next eight months. As a result, the fund will gain 5% on its investment, and its short position will be lost; however, the gains make up for their losses. If TESLA had declined, their long position would've been made up for by shorting.

Merger Arbitrage 

This investment strategy involves taking advantage of the opportunity to trade simultaneously with stocks of 2 merging corporations to create riskless profits. It takes place when there are uncertainties revolving around whether the merger will take place on time or not.

Because of this, when two companies merge, the odds are likely that one company will react well, and the other stock will sell off. Merger arbitrage is a strategy used by hedge funds to take advantage of all scenarios in a merger deal.

A fund manager will decide to go long in stock by buying it and simultaneously shorting it. When executing this strategy, they can either profit from going long or hedge their losses if the stock falls, making it riskless. 

If the merger goes through and both companies are satisfied with the terms, then stock prices will likely rise at least. However, if terms from both companies are not met and the deal does not go through, the fund will make money because of its short position.

Example

If companies ABC and XYZ decide to merge because XYZ cannot get the funding it needs to expand, they have the products and diversity ABC wants. If they come to terms with each other, the fund going long on both companies will likely win. 

On the other hand, if the deal had not gone through because the companies needed to compromise on terms, both companies may have begun to fall. Although they have a short position in both companies, they will likely make money from their short-term trade.

In another scenario, company XYZ and ABC may agree to their merger, but ABC stock falls, and XYZ stock surges to new highs on this news break. As a result, the fund will profit from its short position in ABC and its long position in XYZ.

Convertible Arbitrage 

Convertible arbitrage is a hedge fund strategy in which investors profit from simultaneously purchasing convertible securities and, at the very same time, short-selling the same issuer's common stock.

The fund managers generate profits here by making the most of the opportunity of potential mispricing between the convertible security and the underlying stock.

Sometimes investment funds will buy bonds when the stock prices are low. However, when the stock prices are expected to rise, they can convert the bonds to stock before it does. They can do this when the bond price is ineffectively priced compared to the stock price.

Suppose an investment fund wants to buy a set of convertible bonds with a predetermined convertible stock price of $100. If the firm believes the stock's price will rise, it will convert its bonds to stock. 

Once the firm converts its bond to stock, it sells its stock for the market value of the stock price. This means the firms can open short and long positions on the bonds and sell them for profits. 

Capital Structure Arbitrage

Capital structure arbitrage is a strategy that takes advantage of mispricing the equity and debt securities to generate returns.

Capital structure arbitrage focuses on the valuation differential between debt and equity, to capture alpha by identifying opportunities where perceived valuation exceeds the market valuation.

Stock prices can often be mispriced based on news and other financial or economic events. This investing and trade system takes advantage of those ineffective prices. 

Companies can be over or undervalued in the long run, but they can also be oversold or overbought in the short term. Hedge funds can take advantage of these pricing errors by going long or short in their positions to make money on the potential up and downside. 

Pricing often occurs when companies issue news releases or hold press conferences. Investment funds can take advantage of this opportunity by going long or short on a company's stock.

Example

let's suppose a company had a news release that shows a new study they completed with great results; this sends the stock price soaring. However, the company is not profitable, its financial statements are still a wreck, and they have no real customers. 

An investment fund can realize that the company's price has increased greatly, but the pump will only last a while. The fund can take a short position on the company and make money when it returns to its true valuation. 

Fixed-Income Arbitrage 

Utilizing fixed-income arbitrage means the utilization and exploitation of differences between the interest rates of fixed-income securities. This strategy includes acquiring security at a low price and selling it at a higher comparable price in a limited time frame.

The intention of deploying fixed-income arbitrage is to facilitate investors with a fixed return over a period of time.

This strategy involves going long and short in the bond market. It can be used for government, municipal, and corporate bonds. Two requirements for this strategy are that the bonds used must have enough liquidity and that the bonds chosen must be similar. 

This strategy can carry a considerable amount of risk. Many investment institutions can remember the Long-Term Captial Management crisis. As a result, many can describe this strategy as extremely high risk with low reward, which is not the optimal risk/reward ratio.

Let's suppose that a fund sees a pricing error in the bonds market, they believe the price of bonds is too low, and they will increase soon. So the investment firm will take a long and short position in the bonds to catch either an increase or a decrease in value.

Summary 

Hedge fund strategies are investment strategies that hedge fund managers utilize to generate profits and returns for investors by exploiting the elements in the micro and macroeconomic environment.

These strategies are a combination of approaches, techniques, asset classes, and risk management techniques.

Hedge funds are investment firms that take investors' money and pool it together to make investments. Investment funds can be considered high-risk investments for large investors. As a result, many firms require a minimum investment or net worth from their investors.

Since funds require minimum investments and net worth, they naturally attract wealthier clients. However, the strategies used are considered untraditional, and many do not have the best risk-to-reward ratio. For example, the fixed-income strategy has a low risk/reward ratio. 

The general idea of employing hedge fund strategies is to make investments, and then protect the downside. For example, the long/short strategy will open long and short positions, producing the opposite position to hedge. There is always a hedge to protect against downside exposure.

Hedge funds can invest in various assets, such as fixed-income securities, equities, real estate, and others. This allows them to combine many different investment vehicles to gain a good return for their investors. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Equity Hedge Fund Strategies

• Hedge Clause

• Famous Fund Managers

• Funding Liquidity Risk

• Mezzanine Fund