Hedge Funds Strategies 101

Hedge funds come in many shapes and sizes and are typically privately managed investment funds. They operate many diverse investment strategies that seek to generate returns that are less dependent on the direction of traditional equity, bond, commodity and currency markets. This makes them useful in diversifying traditional risk factors in an investment portfolio. There are a number of well established hedge fund strategies.

Hedge fund strategies

  • “Equity long short” investing is one of the most common and well-known strategies. It is an extension of traditional long only equity investing but adds the ability to sell short and to use leverage. The basis of “equity long short” investing is to seek good companies or undervalued companies and to buy them, while “shorting” poorly run or overvalued companies. A “short” is an asset held in anticipation of a fall in value. By balancing long and short exposures, market risk can be hedged to the desired level.

    Most “equity long short” funds run a net long bias, that is they have more “long” exposure than short exposure. Some of these funds are market neutral and are equally long and short the market. The reason: to hedge out all their market exposure. The risk they are primarily exposed to is company specific risk. Notable equity long short managers include Omega Advisers run by Leon Cooperman and Lone Pine Capital, run by Stephen Mandel.

  • “Credit long short” investing is another strategy. It is less common than “equity long short” investing but the main principles are similar. The manager seeks good and undervalued companies to buy long and poorly run or overvalued companies to sell short. In this case, however, instead of trading in the equity of these companies, the manager buys and sells the debt of the companies.

    These debt instruments include bonds, convertible bonds, bank debt, trade receivables and credit default swaps. One of the most notable credit long short managers is JP Morgan alumnus Andrew Feldstein, whose BlueMountain Capital has performed consistently even through the 2008 crisis.

  • A special case of credit long short is “capital structure arbitrage”. This is a more sophisticated form of “credit long short” that typically involves buying and selling the equity or debt instruments issued by the same company. Company capital structures are sometimes not properly valued because the investors who trade equities and the investors who trade bonds have different objectives. Examples of “capital structure arbitrage” are buying long the senior debt versus selling short the subordinated debt of the same company. In case of default or reorganisation, the recovery value in the senior security is higher than in the subordinated security. This means the investor makes money. Capital structure arbitrage is the preserve of a few specialized funds. One such example is Pine River Capital, a firm based in Minnesota whose mortgage trade made money in the 2008 crisis.

  • “Convertible arbitrage” combines elements of equity, credit and volatility trading. The typical trade in convertible arbitrage is to buy the convertible bond, sell short a proportion of equity, and hedge out the credit risk with credit default swaps or an asset swap. Convertibles can also be used to create high carry levered positions with little equity risk. They also feature in distress or stressed investing.

    Convertible arbitrage was once a much favoured strategy but reliance on excessive leverage has made the strategy less popular among investors. Philippe Jabre, formerly portfolio manager of the GLG Market Neutral Fund remains one of the foremost convertible arbitrageurs with his own Jabre Capital Multi Strategy Fund.

  • “Fixed income arbitrage” refers to non-credit related bond and bond derivative trading. It is usually expressed in sovereign bonds and the two main types of funds come in the form of macro and arbitrage. Macro fixed income investing is based on the premise that pricing in fixed income markets reflect macro conditions and economic policy. Managers seek to make money by having a macro view and expressing it by trading sovereign fixed income securities and derivatives.

    Arbitrage strategies are predicated that relationships between different securities tend to a no-arbitrage position over time. Managers seek inefficiently priced securities and bet that they converge to efficient pricing. Fixed income arbitrage was made famous by the ill-fated LTCM. Today, fixed income arbitrageurs are few and far between.

  • “Distress investing” involves investing in the securities of companies in distress or bankruptcy. This can range from equity to debt, bank debt, credit default swaps, trade claims, and options, among others. These securities are often incorrectly valued and holders of such securities are forced to dispose of them at uneconomic prices. Sometimes the manager will be an activist in steering the outcome of the bankruptcy process.

    “Distress investing” brings together business valuation, legal understanding of bankruptcy processes, trading ability and an understanding of the motivations of incumbent stakeholders from shareholders to creditors to management. The distressed investor par excellence is Randy Smith who pioneered the approach at Bear Stearns some 30 years ago. He remains active today managing Alden Global Capital, a distressed investing hedge fund.

  • “Merger arbitrage” invests in situations where one company is taking over another. It usually involves buying the target company and selling the acquiring company (in a stock offer) or just the target (in a cash offer.) The strategy has evolved to include investing in any hard catalyst (announced deal) situation to include de-mergers or spinoffs, asset sales and other special corporate actions. The strategy seeks to make money by deciding if a situation will evolve as announced or not. More evolved strategies also bet on the path of a situation playing out to completion or a deal breaking down. Notable merger arbitrageurs include the likes of John Paulson, before his excursion into the mortgage market, Tom Sandell and Bernard Oppetit.

  • “Global Macro” is one of the oldest and most well-known hedge fund strategies. Broad types of macro strategies include Fixed Income, the most common type, which avoids the risk inherent in equities or corporate credit; Commodities, which are very much driven by demand and supply and thus correlated to industrial production; FX, which is an extension of fixed income macro with elements of inflation and rates and finally - Equities, which is a less common expression of global macro as it contains the idiosyncratic risk inherent in companies’ financial performance and outlook.