Hedge funds rely on several strategies to make money. Hedge Fund Research, Inc. (HFRI) divides them into four categories:
- Macro strategies
- Event-driven strategies
- Relative value strategies
- Equity hedge strategies
Before exploring hedge fund strategies, first of all, what is a hedge fund?
It is an investment vehicle by which accredited investors’ funds are managed and invested in several asset classes to generate above-average returns and reduce or eliminate risk. Unlike private equity, hedge funds focus on public securities. They employ complex strategies, including using long and short positions, entering into derivatives, and leveraging leverage to generate high profits.
The strategy adopted varies greatly between hedge fund managers. And the four above are the general categories.
Hedge funds rely on a top-down approach when investing. First, they start by analyzing the macro environment as a whole. Then, they scanned for asset classes to target, including stocks, debt securities, commodities, and currencies. They combine:
- Long and short positions for the broad market
- Quantitative and fundamental approach
- Holding period: long and short term
Under this strategy, macro variables are considered to underpin the asset class. Thus, their movements will also affect the prospects for these asset classes. For example, during a recession, a hedge fund might go long in debentures and short in stocks. Bonds are expected to rise in price because the recession forced central banks to intervene in the economy by lowering interest rates to stimulate economic growth. Conversely, stocks fell in price during this period as stock issuers faced slumping business and financial performance.
Event-driven strategies focus on short-term events, which can significantly affect securities. Examples are mergers, acquisitions, and restructurings. Hedge funds start by analyzing companies and aggregating them into potential groups. They then observe key events and trends in their securities and take long and short positions accordingly in the securities issued, including common stock, preferred stock, and fixed-income securities.
This strategy has many variations. Three examples include:
- Distressed restructuring
- Merger arbitrage
Hedge funds focus on companies experiencing financial difficulties but are prospective for improvement. For example, suppose the target company has high debt and is close to default, forcing them to restructure their finances.
Short-term financial difficulties make corporate bonds fall in price. Thus, they are available for purchase at very high discounted prices. Hedge funds target them because, for example, they have a strong market position, which allows them to generate strong cash flows in the future once financial difficulties are overcome. Thus, hedge funds view their bonds as undervalued and take long positions, hoping the price will rise after a successful restructuring.
Hedge funds profit from corporate mergers/acquisitions. For example, an acquirer is willing to pay a 5% premium over the market price. Assume the target company’s current stock price is $10.
Say, the hedge fund then goes long and buys at $12. If the acquisition is successful, the share price is expected to increase to $15, which is close to what the acquirer is willing to pay ($10 + $10 * 5%). Thus, hedge funds can pocket a profit of $ 3 per share ($ 15 – $ 12).
Hedge funds focus on ownership interests in target companies to influence their policies and strategic direction. For example, they suggest target companies divest their subsidiaries or sell certain assets. The goal is to increase the company’s value and, therefore, its share price.
Please remember this is different from what private equity does. Hedge funds focus on public equity, not private equity, as private equity firms focus.
Relative value strategy
Relative value strategies rely on short-term mispricing or price differentials to take advantage of the related securities. Hedge funds use fundamental and quantitative techniques to set targets and take exposure to several associated securities, including equities, debentures, and derivatives.
Relative value strategies take several variations, including:
- Fixed income arbitrage
- Fixed income convertible arbitrage
- Fixed income asset-backed
Fixed income arbitrage. Investment exposure is directed at two different fixed-income securities, for example, between two corporate bonds or between corporate bonds and government bonds.
Fixed income convertible arbitrage. Hedge funds profit from the mispricing between convertible bonds and the underlying stock. They take simultaneous long and short positions, usually buying convertible bonds and selling common stock.
Fixed income asset-backed. Profits are made on the difference in price between various asset-backed securities (ABS) and mortgage-backed securities (MBS).
Volatility. Hedge funds take positions with options to go long or short on market volatility. They may focus on a particular asset class or across asset classes.
Equity hedge strategy
Equity hedge strategies take exposure to public stocks. Again, fundamental analysis is the key to identifying targets.
Meanwhile, exposure to short and long positions varies, depending on the strategy of each hedge fund manager. For example, they may simply take a short position in a few stocks because they are pessimistic about their future. Or, they take short positions in overvalued stocks and long in undervalued stocks and add leverage to positions where it is potentially profitable.
Equity hedge strategies come in many variations, including:
- Market neutral strategy
- Quantitative directional
- Growth fundamentals
- Fundamental values
- Short bias
Market neutral strategy
Hedge funds rely on quantitative analysis to identify undervalued and overvalued stocks. They then take long positions in undervalued stocks and short positions in overvalued stocks. This is a neutral market because the short and long positions have the same market value.
This is similar to a market-neutral strategy. But, hedge funds take exposure to market risk. They increase their exposure to a net long if they expect it to be profitable. And conversely, they will add exposure to net shorts if it does better.
Under this strategy, the hedge fund takes short positions in overvalued and long positions in undervalued stocks. But, unlike the market-neutral approach, they add leverage on short or long positions, depending on which is more profitable. So, for example, if a short position is potentially profitable, they will add leverage to it and vice versa.
This strategy relies on fundamental analysis to identify targets. Hedge funds scan and analyze several companies with high future growth potential and take long positions on their shares. High growth is assumed to drive stock prices up in the future, enabling them to realize the gains from capital appreciation.
Instead of focusing on growth potential, hedge funds focus on a company’s intrinsic value. First, they examined several companies and used fundamental analysis to identify undervalued stocks. Then, they go long in those stocks, hoping their price will rise to reflect their higher intrinsic value.
Short bias focuses on short positions. Hedge funds identify overvalued stocks and take short positions in them. In other words, they predict the stocks will fall in the future and profit from their fall in price. Of course, this can be very detrimental if stocks move in the opposite direction (their prices increase).
Hedge funds take exposure to specific sectors in investing. For example, they targeted the health healthcare sector and invested in companies along the supply chain, including hospitals, pharmaceuticals, healthcare products, and biotechnology.
In other cases, the hedge fund may focus on the commodity sector. They profit from cycles. For example, when the economy is recovering, they take stocks based on non-gold commodities such as oil and base metals because their demand increases, making their prices soar. Conversely, during peaks, they increase their exposure to gold-producing stocks, expecting a contraction or recession to occur and investors hunting for gold to secure their assets.
What to read next
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- The Pros and Cons of Alternative Investment You Need To Know
- Hedge Funds: Examples And What Do They Do?
- Hedge Funds Strategy: Macro, event-driven, relative value, and equity hedge strategies
- Private Equity: Examples, Strategies, Targets, Its Ways To Make Money
- Private Equity Structure and Fee
- Venture Capital: How It Works, How It Makes Money, Investment Horizon
- What Are the 3 Stages of Venture Capital Financing?
- Leveraged Buyout (LBO): How it Works, Funding Sources, Criteria for Target