Hedge Fund Strategies

Hedge fund strategies are a set of principles or instructions followed by a hedge fund in order to protect themselves against the movements of stocks or securities in the market and to make a profit on a very small working capital without risking the entire budget.

List of Most Common Hedge Fund Strategies

  • # 1 Long/Short Equity Strategy
  • # 2 Market Neutral Strategy
  • # 3 Merger Arbitrage Strategy
  • # 4 Convertible Arbitrage Strategy
  • # 5 Capital Structure Arbitrage Strategy
  • # 6 Fixed-Income Arbitrage Strategy
  • # 7 Event-Driven Strategy
  • # 8 Global Macro Strategy
  • # 9 Short Only Strategy

Let us discuss each of them in detail – 

Hedge Fund Strategies

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Source: Hedge Fund Strategies (wallstreetmojo.com)

#1 Long/Short Equity Strategy

Example

  • If Tata Motors looks cheap relative to Hyundai, a trader might buy $100,000 worth of Tata Motors and short an equal value of Hyundai shares. The net market exposure is zero in such a case.
  • But if Tata Motors does outperform Hyundai, the investor will make money no matter what happens to the overall market.
  • Suppose Hyundai rises 20%, and Tata Motors rises 27%; the trader sells Tata Motors for $127,000, covers the Hyundai short for $120,000, and pockets $7,000.
  • If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for $77,000, covers the Hyundai short for $70,000, and still pockets $7,000.
  • If the trader is wrong and Hyundai outperforms Tata Motors, however, he will lose money.

#2 Market Neutral Strategy

Example

  • A fund manager may go long in the ten biotech stocks expected to outperform and short the ten biotech stocks that may underperform.
  • Therefore, in such a case, the gains and losses will offset each other despite how the actual market does.
  • So even if the sector moves in any direction, the gain on the long stock is offset by a loss on the short.

#3 Merger Arbitrage Strategy

Example

Consider these two companies– ABC Co. and XYZ Co.

  • Suppose ABC Co is trading at $20 per share when XYZ Co. comes along and bids $30 per share, a 25% premium.
  • The stock of ABC will jump up but will soon settle at some price, which is higher than $20 and less than $30 until the takeover deal is closed.
  • Let’s say that the deal is expected to close at $30, and ABC stock is trading at $27.
  • To seize this price-gap opportunity, a risk arbitrageur would purchase ABC at $28, pay a commission, hold on to the shares, and eventually sell them for the agreed $30 acquisition price once the merger is closed.
  • Thus the arbitrageur makes a profit of $2 per share, or a 4% gain, less the trading fees.

#4 Convertible Arbitrage

Example

  • Visions Co. decides to issue a 1-year bond that has a 5% coupon rate.  So on the first day of trading, it has a par value of $1,000, and if you held it to maturity (1 year), you would have collected $50 of interest.
  • The bond is convertible to 50 shares of Vision’s common shares whenever the bondholder desires to get them converted. The stock price at that time was $20.
  • If Vision’s stock price rises to $25, the convertible bondholder could exercise their conversion privilege. They can now receive 50 shares of Vision’s stock.
  • Fifty shares at $25 are worth $1250. So if the convertible bondholder bought the bond at issue ($1000), they have now made a profit of $250. If they decide that they want to sell the bond, they could command $1250 for the bond.
  • But what if the stock price drops to $15? The conversion comes to $750 ($15 *50). If this happens, you could never exercise your right to convert to common shares. You can then collect the coupon payments and your original principal at maturity.

#5 Capital Structure Arbitrage

  • It is a strategy in which a firm’s undervalued security is bought, and its overvalued security is sold.
  • Its objective is to profit from the pricing inefficiency in the issuing firm’s capital structure.
  • It is a strategy used by many directional, quantitative, and market neutral credit hedge funds.
  • It includes going long in one security in a company’s capital structure while at the same time going short in another security in that same company’s capital structure.
  • For example, long the sub-ordinate bonds and short the senior bonds, long equity, and short CDS.

Example

An example could be – A news of a particular company performing poorly.

In such a case, both its bond and stock prices are likely to fall heavily. But the stock price will fall by a greater degree for several reasons like:

#6 Fixed-Income Arbitrage

Example

A Hedge fund has taken the following position: Long 1,000 2-year Municipal BondsMunicipal BondsA municipal bond is a debt security issued by a national, state, or local authority to finance capital expenditures on public projects related to the development and maintenance of infrastructures such as roads, railways, schools, hospitals, and airports.read more at $200.

  • 1,000 x $200 = $200,000 of risk (unhedged)
  • The Municipal bonds payout 6% annual interest rate – or 3% semi.
  • Duration is two years, so you receive the principal after two years.

After your first year, the amount that you have made assuming that you choose to reinvest the interest in a different asset will be:

$200,000 x .06 = $12,000

After two years, you will have made $12000*2= $24,000.

But you are at risk the entire time of:

  • The municipal bond is not being paid back.
  • Not receiving your interest.

So you want to hedge this duration risk.

The Hedge Fund Manager Shorts Interest Rate SwapsInterest Rate SwapsAn interest rate swap is a deal between two parties on interest payments. The most common interest rate swap arrangement is when Party A agrees to make payments to Party B on a fixed interest rate, and Party B pays Party A on a floating interest rate.read more for two companies that pay out a 6% annual interest rate (3% semi-annually) and are taxed at 5%.

$200,000 x .06 = $12,000 x (0.95) = $11,400

So for 2 years it will be: $11,400 x 2 = 22,800

Now if this is what the Manager pays out, then we must subtract this from the interest made on the Municipal Bond: $24,000-$22,800 = $1,200

Thus $1200 is the profit made.

#7 Event-Driven

Example

One example of an Event-driven strategy is distressed securities.

In this type of strategy, the hedge funds buy the debt of companies in financial distress or have already filed for bankruptcy.

If the company has yet not filed for bankruptcy, the Manager may sell short equity, betting the shares will fall when it does file.

#8 Global Macro

  • This hedge fund strategy aims to profit from massive economic and political changes in various countries by focusing on bets on interest rates, sovereign bonds, and currencies.
  • Investment managers analyze the economic variables and what impact they will have on the markets. Based on that, they develop investment strategies.
  • Managers analyze how macroeconomic trends will affect interest rates, currencies, commodities, or equities worldwide and take positions in the asset class that is most sensitive in their views.
  • A variety of techniques like systematic analysis, quantitative and fundamental approaches, long and short-term holding periods are applied in such cases.
  • Managers usually prefer highly liquid instruments like futures and currency forwards for implementing this strategy.

Example

An excellent example of a Global Macro Strategy is George Soros shorting of the pound sterling in 1992. He then took a massive short position of over $10 billion worth of pounds.

He consequently profited from the Bank of England’s reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float the currency.

Soros made 1.1 billion on this particular trade.

#9 Short Only

Top Hedge Fund Strategies of 2014

Below are the Top Hedge Funds of 2014 with their respective hedge fund strategies-

Top Hedge Fund Listssource: Prequin

Also, note the hedge funds Strategy distribution of the Top 20 hedge funds compiled by Paquin

Breakdown of Top 20 hedge fund by strategies 1

source: Prequin

  • Top hedge funds follow Equity Strategy, with 75% of the Top 20 funds tracking the same.
  • Relative Value strategy is followed by 10% of the Top 20 Hedge Funds.
  • Macro Strategy, Event-Driven, and Multi-Strategy make the remaining 15% of the strategy.
  • Also, check out more information about Hedge Fund jobs here.
  • Are Hedge Funds different from Investment Banks? – Check this investment banking vs hedge fund

Conclusion

Hedge Funds do generate some outstanding compounded annual returns. However, these returns depend on your ability to properly apply Hedge Funds Strategies to get those handsome returns for your investors. While most hedge funds use Equity StrategyEquity StrategyAn equity strategy is a long-short strategy on equity stock which involves taking a long position on those shock which are bullish (i.e., expected to increase its value) and taking a short position on stocks which are bearish (i.e., expected to decline or fall its value) and hence booking a sufficient profit from the difference.read more, others follow Relative Value, Macro Strategy, Event-Driven, etc. You can also master these hedge fund strategies by tracking the markets, investing, and learning continuously.

Reader Interactions

Comments

  1. kiirran says

    Thanks Dheeraj for layman approach in conveying the message.
    Wonderful and worth the time invested in reading.

    Thanks Again for your help in providing the insight into 2 different worlds which are pretty away from common man.

    • Dheeraj Vaidya says

      Thanks Kirran!

  2. Natasha Kishnani says

    Have read many articles related to Hedge funds strategies, but I found this article full of details and useful content. Great sharing :)

    • Dheeraj says

      thanks Natasha!

  3. Navya Rahulkar says

    Thanks for this Article Dheeraj. I am reading your articles and enjoying them thoroughly. I have the following question, though: If I want to be in Hedge funds, will doing CFA help me?

    • Dheeraj says

      Hi Navya,

      Thanks! If you want to move into Hedge fund, CFA will surely help. Do register for the same.

      All the best,
      Dheeraj

  4. Akia Orlov says

    Dheeraj another great post. Great!!!

    For Hedge Funds I have heard that there is some minimum investment requirement. I wanted to know if it is the same or does it vary country wise or Fund-wise?

    • Dheeraj says

      Thanks Akia, Since each fund is unique with respect to its strategy and objective, i think the minimum investments requirements would be different depending on the country or the type of fund.

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