Jan 21, 2025

Hedge Fund Strategies

Market observers often generalize about hedge funds. Although they do share common traits, they also employ a diverse array of strategies, potentially making individual hedge funds remarkably distinct from one another. This diversity is not only fascinating but also crucial for investors to understand. While there are dozens of strategies, this post delves into seven of the most prevalent, providing a high-level overview of the field.

Three Types of Strategies

To help investors figure out how to invest in these products, the hedge fund industry has created three categories that cover most strategies.

Relative value strategies typically combine long and short positions in highly correlated securities on the premise that one is relatively cheap compared to the other, assuming their convergence to their “true” fundamental value should produce a net profit.

Event-driven strategies aim to take advantage of a particular event, presumably giving way to some security mispricing. Such events include merger offers and financial distress.

Finally, directional strategies take bets on the appreciation or depreciation of stocks, bonds, currencies, crypto assets, and/or commodities.

Relative Value Strategies

One relative value strategy is convertible arbitrage. A convertible debenture is a corporate bond that allows holders to convert their bonds into company stocks at a fixed ratio to their par value. For example, a convertible debenture can offer an option to convert into ten stocks for each $1,000 of the bond’s face value. Under this scenario, converting could be profitable if the stock price climbs above $100. A convertible arbitrage hedge fund will typically try to take advantage of moments when the debenture is “cheap” relative to the stock by buying the former and selling short the latter.

Another strategy is fixed-income arbitrage. One version is the yield curve arbitrage, which involves simultaneously buying and selling two government bonds with different maturities, hoping that prices will eventually realign at a net profit. Another strategy is credit arbitrage, an example of which would be acquiring undervalued corporate bonds and selling short overvalued bonds of firms from the same sector or even the same issuer. The most famous fixed-income arbitrage hedge fund was Long Term Capital Management, which, after delivering returns of 43% in 1995, 41% in 1996 and 21% in 1997, collapsed in 1998 following a disastrous leveraged bet on Russian debt.

However, the poster child of relative value strategies is the equity market-neutral portfolio. A prominent way to implement this strategy is to buy undervalued stocks and sell short equity index futures to offset the beta of the portfolio. In theory, such a portfolio will be insensitive to the ups and downs of the stock market, leaving only the value added from the manager’s skillful stock selection. In practice, one-quarter of market-neutral funds have been found to exhibit significant market risk.

Event-Driven Strategies

Merger arbitrage strategies exploit opportunities in stocks of companies engaged in corporate transactions. When a firm makes a tender offer to acquire another at a fixed price, it usually bids at a premium above the stock’s current price. Of course, after such a bid is announced, the target firm’s stock usually appreciates, but will usually fall short of the bid price. Merger arbitrage funds typically take a long position in the target company’s stock following the tender offer announcement. The fund will make a profit if the acquisition is consumed. However, under the best scenario, the potential acquirer or another suitor (often labelled as a “white knight”) will raise their bid to convince reluctant shareholders of the target firm to approve the transaction, leading to an outsized profit for the hedge fund. This strategy is not without risk, however. If the shareholders reject the offer and no one else shows up with a higher bid, the target firm’s stock may fall back to where it was before the tender offer, possibly with severe losses to the merger arbitrage fund.

Distressed debt funds, sometimes called vulture funds, invest in bonds of companies with serious financial problems. Most bond investors do not have the wherewithal to manage distressed debt, often requiring creditors to negotiate a complex restructuring. When regular investors sell their position, the issuing company is usually in such bad shape that there is very little demand for its bonds. Distressed debt funds specialize in acquiring these securities at fire-sale prices, then engage in restructuring or bankruptcy proceedings to extract as much value as possible from their holdings. Since they bought the bonds at a deep discount, they do not need to recover their full face value to make a handsome profit. Of course, the negotiations can also turn sour for the distressed debt fund, resulting in a severe loss.

Directional Strategies

Equity long/short funds adopt a similar stance to an equity market-neutral strategy but with no intention of neutralizing the beta of the portfolio. They simply buy stocks they believe will appreciate and sell short stocks they expect to fall in value to net a profit. Long/short hedge funds were likely involved on both sides of the GameStop mania of 2021.

Based on a macroeconomic scenario, global macro funds bet on stocks, interest rates, currencies, crypto assets and commodities. For example, if the manager believes the US Federal Reserve will raise interest rates, it may take a short position on interest rate futures. In a famous hedge fund operation, manager George Soros earned over $1 billion on a massive short position on the British Pound in 1992 when he correctly predicted the UK would devalue its currency. Soros was dubbed “the man who broke the Bank of England” then.

Hedge fund strategies can be complex, as can their fee structures. Since outsized fees are an unavoidable feature of hedge funds, there is a big difference between how much profit they generate and what the end investor will earn. Our next post will take a deep dive into hedge fund fees.

 

About The Author
Raymond Kerzérho
Raymond Kerzérho

Raymond contributes to PWL with his thirty years of experience in investment strategy and fixed income portfolio management.

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