Demystifying the World of Hedge Funds: What is a Hedge Fund?

A Hedge Fund is an investment vehicle comprised of an onshore management company and an offshore entity that holds clients’ money on the account.

The aim of a hedge fund is to protect the capital of their clients (investors) by making money in both rising and falling markets. Their aim is to generate high returns with the lowest possible risk.

They are called hedge funds because their role is to run well diversified and hedged investment portfolios using systematic or proprietary strategies.

Hedge funds require less regulation from the Securities and Exchange Commission since they address accredited investors.

The management company charges an annual management fee (typically 1%-2%) on assets under management (AUM) and an annual performance fee on any profits they make to their clients (investors).

Investors in the fund will require the hedge funds portfolio managers to initially invest in the fund their own funds and reinvest typically 50% of the performance fee earned every year back into the fund.

Hedge Funds Investment Strategies

Hedge funds use different investment strategies to generate consistent returns while minimising the risk of the portfolio. Depending on the strategies followed hedge funds are categorised in the following groups:

Global Macro

Global Macro, short for global macroeconomics, is the strategy of analysing how macroeconomic and geopolitical trends and events affect stocks, bonds, commodities, currencies across the world and structure an investment portfolio of diversified positions by taking long or short position in different asset classes. It is one of the most important strategies for any investor, since global events influence all types of investments.

Some of the most famous global hedge fund managers include George Soros and Paul Tudor Jones.

The four basic approaches of global macro are discretionary, systematic, high frequency and commodity trading advisors (CTAs).

Discretionary Trading

Discretionary macro trading relies on the trader’s experience, intelligence and knowledge to structure investment portfolio based on subjective decisions on various global markets. The investor takes a top-down approach to analyse economies and markets. This allows him to analyse risks and opportunities across industries, sectors, and countries.

Systematic Trading

Systematic macro hedge funds employ a top-down model taking various economic indicators into account. They use a large set of quantitative data and systematic macro strategies to generate consistent returns. Systematic macro involves lengthy quantitative research performed by quantitative analysts.. Holding periods for systematic macro can range from days to months or longer. Bridgewater founded by Ray Dalio and AQR capital management are two of the most successful systematic macro hedge funds.

High Frequency Trading

A third of global macro trading is high frequency trading. These types of funds use highly sophisticated technology to trade very short-term (millisecond) dislocations in different markets. In high frequency trading, processing speed is the most important factor to ensure consistent returns

Commodity Trading Advisors (CTAs)

Most CTAs utilise automated trend-following strategy that is similar to systematic macro. CTAs perform very well over longer periods of time but are subject to large drawdowns during certain periods. AHL and Winton Capital Management are the largest CTAs.

Long/Short Equity

Long/Short funds analyse equities using quantitative, technical, and fundamental methods to identify expected winners and losses. They take long positions in the expected sectors, industries or specific stocks they expect to outperform the market and short positions in the losers. The combined portfolio has reduced market risk since long positions are offset by short positions exposure.

Managers can shift from value to growth, from small to medium to large cap stocks, and from a net long position to a net short position. The financial assets monitored may be regional such as Long/Short US or European equities or sector specific.

For example, if the hedge fund expects high financial risk and an economic recession it may go long the healthcare sector which is a defensive sector and will outperform the market and go short the construction sector which is a cyclical sector highly sensitive to economic conditions which under performs the market.

Convertible Arbitrage

This strategy focuses on investing in the convertible securities of a company. Investment positions are designed to generate profits from the fixed income security and the short sale of the stock, while reducing market risk by protecting the principal from market moves. A typical investment is to be long in the company’s convertible bond and short its common stock. Convertible arbitrage outperforms most strategies when market volatility is high.

Dedicated Short Bias

Short only hedge funds focus on identifying and betting against overvalued stocks. Their strategy is based mainly on analysing the financial statements of companies in detail to identify company issues not yet valued by the market. Short-only funds act as a portfolio hedge during bear markets.

Equity Market Neutral

This investment strategy tries to exploit equity market inefficiencies and involves being simultaneously long and short equity portfolios of the same size. Market neutral portfolios are designed to be beta neutral, currency neutral or both. Market neutral hedge funds target zero net-market exposure. Market neutral portfolios control sector, industry, and other exposures. Since market neutral strategy has lower risk and returns than a long-biased strategy leverage is applied to enhance returns.

Event Driven

This strategy is designed to capture price movements generated by a pending corporate event like a merger, corporate restructuring, liquidity or bankruptcy. Event driven strategies are categorised as: risk arbitrage, distressed arbitrage and multi-strategy.

Risk Arbitrage

This strategy involves investing simultaneously in long and short positions for both companies involved in a merger or acquisition. Risk arbitrageurs are typically long the stock of the company being acquired and short the stock of the acquiring company. The principal risk of this strategy is the risk of the deal failing.

Distressed Arbitrage

Hedge fund managers invest in debt or equity of companies in financial distress or bankruptcy. These securities trade at substantial discounts to par value. A typical example of an event-driven strategy is a hedge fund buying the debt of a distressed company or a company which have filed bankruptcy at a heavy discount in anticipation to be repaid at par or with a small haircut during the company’s reorganisation. Managers may also take arbitrage positions within a company’s capital structure, by purchasing senior debt and short-selling common stock, in anticipation of realising returns from the shift in this spread.

Multi-strategy Funds

Multi-strategy funds invest in multiple themes, including risk arbitrage, distressed securities and investments in small cap companies raising funds in private capital markets.

Fixed Income arbitrage

The fixed-income arbitrage hedge fund aims to profit from price anomalies between related interest rate securities. This strategy includes interest rate swap arbitrage, Government bond arbitrage, forward yield curve arbitrage and mortgage-backed securities arbitrage.

If you are an amateur investor or trader check our guide on how to invest money.

If you are interested in becoming am active trader yourself and learn how to trade stocks, bonds, commodities and currencies check our guides on stock trading, bonds investing, forex trading and day trading.

Alternatively, if you are interested in structuring your systematic low-risk investment strategy yourself without relying on financial advisors and investment firms check our asset allocation guide.

MacroVar systematic investment strategies database will help you generate new systematic strategies.