Within the investment industry, there are many different strategies that can be utilized in an attempt to get a greater return on the capital invested. As such, there are many different types of hedge funds with a diverse realm of investing styles. For the most part, all of the fund types fall into one of five categories or styles: macro, event driven, arbitrage, long/short and tactical trading.
Convertible Arbitrage– is a long/short equity strategy, but rather than buying stock in one company while selling short the stock of another company, convertible arbitrage buys convertible securities of the company and short-sells the common stock of the same company. Usually the convertible security is a convertible bond that can be converted into common stock at some point in the future. This strategy attempts to take advantage of any pricing inefficiencies. Risk expectancy- low to moderate.
Distressed Securities- this strategy involves purchasing the securities of companies that are in distress, facing potential bankruptcy or restructuring. The securities are usually in the form of bonds, but bank debt, trade claims, preferred stock or even common stock can be included in the strategy. Because the company is in distress and investors are well aware of the issues, the securities the fund is looking to purchase are selling at deep, deep discounts. Risk expectancy- moderate.
Emerging Markets- funds of this variety invest in the securities of emerging market countries and the companies within those markets. There is no clear definition of what an emerging market is, but the general description is a country that is developing and has a low per-capita income compared to other, more developed nations. The growth in emerging economies tends to be more volatile and is accompanied by higher inflation rates. Risk Expectancy- High.
Event-Driven Investing- this strategy is more open to interpretation than most of the other fund styles. The reason for the open interpretation is due to the various events that can occur. An “event” could include an IPO, a merger, an earnings disappointment, an acquisition or even a spinoff. The idea is that when the news comes out, price inefficiencies tend to occur before and after such aforementioned events. The fund managers attempt to take advantage of the inefficiencies to boost returns. Risk Expectancy- Moderate.
Equity-Long Only- investing only in stocks and only going long, this style of trading is more like a traditional mutual fund than any other hedge fund strategy. The fund managers managing this type of fund must be able to stand out considerably if they are going to attract investors and in order to be able to justify their fees. The risk for this type of fund is a prolonged bear market that takes down almost all sectors. Risk Expectancy- High.
Equity Short- the opposite of equity-long only, the equity short fund looks to benefit from stocks that are expected to fall in price by short-selling the stock. Within this category of funds there are two separate types—short-only and short-biased funds. A short-only fund can only make bearish bets while a short-biased fund has the majority of its assets tied up in bearish holdings. These funds can be extremely profitable, especially during an overall bear market. Risk Expectancy- High.
Fixed-income arbitrage- like the other arbitrage funds, fixed income funds try to take advantage of price differences between two securities, they just happen to do it in the fixed income market only. Securities involved in fixed income arbitrage can include corporate bonds, municipal bonds, treasuries or even credit default swaps. These funds tend to have a high winning percentage on their trades with smaller gains. The losses they take can be large, but tend to be less frequent. Risk expectancy- moderate.
Fund of Hedge Funds- as the name suggests, a fund of hedge funds is a portfolio of hedge fund investments. The idea is to spread the assets around to different hedge fund managers and to different styles of hedge funds. The ultimate goal being to lower risk and volatility while increasing the returns. Funds of funds can blend strategies or they may stay within one strategy and just diversify through managers. Risk Expectancy- low to moderate.
Long/Short Equity- one of the most flexible types of funds, the long/short equity strategy allows the manager to hold a long portfolio as well as a short portfolio. Fund managers buy the stock of companies they expect to outperform and short sell the stock of the companies they expect to underperform. Because of the balanced approach, the correlation to the overall market is low. They can be net long, net short or market neutral. Risk Expectancy- low to moderate.
Macro- macro funds are among the more diverse types of hedge funds. They can invest in stocks, bonds, currencies and commodities. Regardless of the investment vehicles that are being used, at the heart of the strategy is the search for global opportunities. These funds look to invest in situations created by changes in government policy, economic policy and interest rates. Macro funds tend to use derivatives and can be highly leveraged. Risk Expectancy- High.
Market Neutral- market neutral funds are similar to equity long-short funds in that they seek returns that are totally independent of market performance. These funds attempt to minimize or eliminate market volatility. One strategy would be holding equal long and short positions within the same sector. This type of strategy puts an emphasis on stock selection and analysis. Market neutral funds may use leverage to enhance returns and they may use derivatives to hedge the overall portfolio. Risk Expectancy- Low.
Merger Arbitrage- merger arbitrage funds are actually a sub-section of event-driven funds. The fund simultaneously buys and sells the stocks of two merging companies. Typically when an announcement is made that one company intends to acquire another company, the stock of the company being acquired jumps in price, but it usually trades below the offer price. The discount is due to the uncertainty of whether the merger will actually go through or not. If the transaction involves an exchange of stock, the stock of the acquiring company tends to decline in value. Risk Expectancy- low to moderate.