Types of Hedge Funds

By
Paul Milnes

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Hedge funds can be loosely categorized in terms of their strategic focus, with most of them falling into one of the following four strategy groups:

  • Equity Hedge Funds
  • Global Asset Allocation Funds
  • Relative-value Funds
  • Event-driven Funds

But before we get into defining these, let’s look at the meanings of some of the key terms that are used to describe these strategies:

Leverage

This is a technique that has been used since the halcyon days of hedge funds to increase returns, and its over-use has been cited as a prime cause in several financial catastrophes. However, when used advisedly and within an overall risk-management strategy, it can be a highly effective way of maximising profits. Basically, it involves using the money in a fund as collateral to borrow more money to invest with. Although there are various financial instruments that can be used to achieve this, the principle remains the same. For instance, if you have $1,000 to invest, you might be able to buy 10 shares in Apple with it. If, however, you used that $1,000 as collateral, or margin, to borrow $100,000, you could buy 1,000 Apple shares. Then, if the share price appreciated by $1, you could sell the shares at a profit. Without leverage, your profit from 10 shares would be $10, but with the 100:1 leverage (i.e. borrowing 100 times the collateral amount), the profit would be magnified to $1,000. The downside of this is that if the leveraged trade lost more than $1 per share, it would lose more than the initial investment of $1,000 – which as you can imagine, can be problematic on a larger scale.

Short Selling

From a layman’s perspective, the concept of long trades – buying a financial instrument in the hope that you can later sell it at a higher price – makes perfect instinctive sense. By contrast, the idea of short trades – selling something that you have never owned in the first place – seems counter-intuitive. Yet, there are ways and means to achieve this, and this is in fact one of the principal strategies used by professional day traders, to the extent where it is used almost as frequently as the long trading technique. In a nutshell, short selling is a method for making money when a financial instrument goes down in price, and given the up-and-down nature of the markets, this is a very useful tool for a trader to have at their disposal.

Market Neutral Equity

This is a strategy that seeks to exploit differences in stock prices by being simultaneously long and short in stocks within the same sector, industry, market, country, etc. From a stock-pickers perspective, this is the ultimate strategy, because you only need to identify a stock that is likely to move, rather than a stock that is destined to move upwards in price. So, for example, you might buy $1k worth of McDonald’s stock while shorting $1k worth of Burger King shares, creating a natural hedge against all other market factors.

As is the case with traditional equity managers, these funds cast an eye over individual companies and individual stocks. Using techniques such as leverage and short selling, these funds are aimed at producing an attractive positive return, whether the market is going up or down. Even if the stock markets are sinking, these funds are aimed at making a profit out of the markets, rather than mirroring or slightly bettering their performance.

There are several sub-categories of this type of equity hedge fund. These include:

  • Growth vs. Value
  • Domestic vs. International equities
  • Capitalization Spectrum: Large, Mid, or Small Cap
  • Directional Bias: Long biased, Short biased, or Opportunistic
  • Bias is defined as at least 50% net exposure. For instance, if a manager is 100% gross long and 50% gross short, and if the short positions really “hedge” half of the long exposure, then the manager is net 50% long. This category includes the sub-category of short-only funds.

Fund managers that fall into the ‘opportunistic’ category’ are biased neither towards short or long trades. However, they can be divided into the following two sub-categories:

Aggressive Managers – these are sometimes more than 50% long in net terms and other times more than 50% net short.

Defensive Managers – these prefer to remain inside the 50% exposure band at all times. However, unlike market neutral equity managers, these managers make no attempt to be “hedged” in all circumstances.

Fund managers that fall inside these two categories are focused on broad markets and broad themes. For example, some global asset allocators are Commodity Trading Advisers (CTA), who invest only in futures contracts rather than individual stocks or bonds, while others follow a wide range of markets including global stock and bond markets, currency markets, and the physical commodities markets. They might be long, short or have no position at all.

Aggressive Managers

This category can be further divided into two subcategories:

Discretionary Managers – These formulate their opinions based largely on their personal experience, and their judgement.
Systematic Managers – These managers base their decisions upon rules, rather than their own judgement and experience.

In most cases, these fund managers operate Market-Neutral Funds – funds that are genuinely hedged. They choose securities from within a relatively homogeneous universe, balancing long positions against short positions in such a way that the hedged portfolio will be relatively unaffected by the general movement of the general market indices.

Defensive Managers

This category of funds can be divided into four subcategories:

  • Long/Short Equity Funds – these buy stocks in attractive companies and sell short stocks in unattractive companies.
  • Bond Hedgers – these buy higher yield bonds and sell short unattractive bonds, so the portfolio has positive carry.
  • Convertible Hedgers – these specialize in convertible securities, which are bonds or preferred stocks, that include a call option on the equity of the issuing company. They buy the convertible security and then sell short the underlying common stock.
  • Multi-strategy Funds – build diversified portfolios using some combination of the above strategies.

In the main, these funds use company-specific strategies that are focused on transactions that affect the organizational structure of companies.

Within this structure, there are two main subcategories:

  • Risk Arbitrage – this is a stock-oriented strategy that takes advantage of the special opportunities that arise when companies decide to buy or merge with others.
  • Distressed Debt Investing – this strategy takes advantage of the special opportunities that arise when companies in financial distress undergo financial restructuring.

The returns from these funds have little or no correlation with the equity markets as a whole, since their returns depend on the outcome of specific deals and not on variables such as earnings growth, PE ratio, or interest rates.

In recent years, the formats of ‘fund of hedge funds’ and multi-strategy funds have become prevalent.

Fund of Hedge Funds

A fund of funds is an investment fund that gives an investor instant exposure to several different hedge funds through one fund investment. The manager of this type of fund typically researches dozens or hundreds of hedge fund managers in order to optimize and invest for clients in a basket of well-performing hedge funds. The downside, from a private investor’s point of view, is that they are doubling up on management and performance fees, which are already embedded in this type of investment.

Multi-Strategy

This is a type of single fund that employs several different strategies simultaneously. They typically charge a single layer of fees, similar to any other fund, and are more diversified than single strategy funds, but not to the same extent as the aforementioned fund of hedge funds model. However, they are not disadvantaged by the doubling up of fees that are implicit in the funds of funds model.

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