A hedge fund is a private, unregistered investment pool that encompasses all types of investment funds, companies, and private partnerships that can use a variety of investment techniques such as borrowing money through leverage, selling short, derivatives for directional investing, and options. Hedge fund managers are constantly trying to find new ways to take advantage of the market’s inefficiencies in order to generate “absolute returns”—posting returns in the black each year, no matter what the overall market does.
During the early years of the hedge fund industry (1950s–1970s), the term “hedge fund” was used to describe the “hedging” strategy used by managers at the time. “Hedging” refers to the hedge fund manager making additional trades in an attempt to counterbalance any risk involved with the existing positions in the portfolio. Hedging can be accomplished in many different ways but the most basic technique is to purchase a long position and a secondary short position in a similar security. This is used to offset price fluctuations and is an effective way of neutralizing the effects of market conditions. Today, the term “hedge fund” tells an investor nothing about the underlying investment activities, similar to the term “mutual fund.” So how do you figure out what the hedge fund manager does? You can figure out a little more about the underlying investment activities by understanding the trading/investment strategies that the hedge fund manager states he or she trades. The “investment strategy” is the investment approach or the techniques used by the hedge fund manager to have positive returns on the investments. Here’s a basic overview of the valuation process that a hedge fund manager or analyst goes through in picking stocks to invest in and a few of the most popular trading/investment strategies:
Valuation Process
When an analyst is looking to value a company (to determine what he or she thinks should be the correct stock price) they go through a process to determine what they believe the stock price to be. This is similar to the process of buying new clothes or buying a car or house when you figure out how much it is worth to you and how much you are willing to pay. You are looking for the best deal available—if a price is above what you are willing to pay, you do not buy the product; if the price is below what you are willing to pay, you do buy it.
According to Frank K. Reilly and Keith C. Brown in their book Investment Analysis and Portfolio Management, there are two basic approaches to valuing stocks: the “top down” and the “bottom up” process:
The “Top Down” (Three Step) Process
The manager believes that the economy, the stock market, and the industry all have a significant effect on the total returns for stocks.
The three-step process is:
- Analysis of alternative economies and security markets. Decide how to allocate investment funds among countries and within countries to bonds, stocks, and cash.
- Analysis of alternative industries. Decide based upon the economic and market analysis, determine which industries will prosper and which will suffer on a global basis and within countries.
- Analysis of individual companies and stocks. Following the selection of the best industries, determine which companies within these industries will prosper and which stocks are under/overvalued.
The “Bottom Up” (Stock Valuation, Stock Picking) Approach
Investors who employ the bottom-up stock picking approach believe that it’s possible to find stocks that are under and overvalued, and that these stocks will provide superior returns, regardless of market conditions.
How to Value These Assets?
Without going into the complex valuation methodologies, the basic process of valuation requires estimates of (1) the stream of expected returns and (2) the required rate of return in the investment. Once the analyst has calculated these expected returns he or she can then compute his expected value of the stock.
Hedge Fund Trading Strategies
Fixed Income Arbitrage
Fixed income arbitrage (also known as relative value arbitrage) involves taking long and short positions in bonds and other interest rate–sensitive securities. The positions could include corporate debt, sovereign debt, municipal debt, swaps, and futures.
The fixed income manager invests in related fixed income securities whose prices are mathematically or historically interrelated, but the hedge fund manager believes this relationship will soon change. Because the prices of these fixed income instruments are based on yield curves, volatility curves, expected cash flows, and other option features, the fixed income managers use sophisticated analytical models to highlight any potential trading opportunities. When these sophisticated models highlight relationships of two or more bonds that are out of line, the manager buys the undervalued security and sells the overvalued security.
Convertible Arbitrage
Convertible arbitrage encompasses very technical and advanced hedging strategies. At its simplest, the hedge fund manager has bought (and holds) a convertible bond and has sold short the overvalued underlying equities of the same issuer. The manager identifies pricing inefficiencies between the convertible bond and stock and trades accordingly.
Statistical Arbitrage
Statistical arbitrage encompasses a variety of sophisticated strategies that use quantitative models to select stocks. The hedge fund manager buys undervalued stocks and sells short overvalued stocks. This is also referred to as the “black box” strategy since computer models make many of the trading decisions for the hedge fund manager.
Equity Market Neutral
The most popular statistical arbitrage strategy is equity market neutral. An equity market neutral strategy (also known as statistical arbitrage) involves constructing portfolios that consist of approximately equal dollar amounts of offsetting long and short positions. The equity market neutral strategy is one that attempts to eliminate market risk by balancing long and short positions equally, usually offsetting total dollar amount of long positions with an equal dollar position amount of short positions. Net exposure to the market is reduced because if the market moves dramatically in one direction, gains in long positions will offset losses in short positions, and vice versa. If the long positions that were selected are undervalued and the short positions were overvalued, there should be a net benefit.
Long/Short Equity
Long/short equity strategies involve taking both long and short positions in equity. Unlike market neutral portfolios, long/short equity portfolios generally have some net market exposure, usually in the long direction. This means that managers are “long biased” when they have more exposure to long positions than short. Long/short fund managers may operate with certain style biases such as value or growth approaches and capitalization or sector concentrations.
Distressed Securities (High Yield)
Distressed investing strategies consist of investing in companies that are experiencing financial difficulties (i.e., possible bankruptcies). These companies are usually priced very low due to the risk of default—most mutual funds cannot invest in companies whose credit ratings fall below secure—therefore these hedge funds can take advantage of very low prices.
Commodities
Most of the time, hedge funds simply see commodity trading as yet another tool for hedging against risk and increasing returns. They trade commodity futures much like any other investor. Investing in commodities used to be a popular strategy, but the emergence of computer-driven funds and high-frequency trading (which have cut the number of short-term trading opportunities), have reduced interest in this strategy.
Currencies
Hedge funds have taken to playing the currency markets as another way to find alpha. Investing in foreign equities or bonds often require that investment to be made in local currency. In a good investment, the fund will not only see returns based on the investment itself, but also in a beneficial exchange rate. In recent years, hedge funds and other investors have also used the carry trade to boost returns. In this scenario, a hedge fund hoping to leverage a trade will borrow money from a bank in a country that has a low interest rate.
In recent years, hedge funds have begun investing in cryptocurrencies. The financial Web site Motley Fool defines cryptocurrency as “an electronic cash system that doesn't rely on central banks or trusted third parties to verify transactions and create new units. Instead, it uses cryptography to confirm transactions on a publicly distributed ledger called the blockchain, enabling direct peer-to-peer payments.” The most popular type of cryptocurrency is Bitcoin. Total assets under management of crypto hedge funds surveyed by PwC for its Annual Global Crypto Hedge Fund Report 2022 were $4.1 billion in 2021, up 8 percent from 2021. The entire cryptocurrency market had a capitalization of $1.06 trillion in 2023, according to Statista.com, up from $237 billion in 2019.
Private Equity
Hedge funds are playing an increasingly important role in taking companies private. At times they partner with more traditional private equity firms, while other times they’ll buy up the bonds used as leverage in the buyout, or even directly extend credit to the buyers in exchange for a stake in the company. The returns are generally longer-term than most hedge funds are used to, so only the biggest hedge funds generally engage in any private equity plays. “Between 2010 and 2015, hedge funds averaged 200 private deals a year, and the trend has continued to shift higher since then,” according to Forbes. “Last year [2020] was the largest year for hedge fund involvement in the private markets, with funds participating in 753 deals worth $96 billion.”
Real Estate
Hedge funds have increasingly invested in hard assets, particularly real estate. Commercial real estate, in particular, has remained strong. Commercial leasing can provide steady returns for hedge funds, which can hedge against risks in other markets. And commercial real estate has generally appreciated in value far more consistently than residential holdings.
Event-Driven
An “event-driven” fund is a fund that utilizes an investment strategy that seeks to profit from special situations or price fluctuations. Various styles or strategies may be simultaneously employed. Strategy may be changed as deemed appropriate—there is no commitment to any particular style or asset class. The manager invests both long and short in equities or fixed income of companies that are expected to change due to an unusual event.
Sector
Sector strategies invest in a group of companies/segment of the economy with a common product or market. The strategy combines fundamental financial analysis with industry experience to identify the best profit opportunities in the sector. Examples could be the health care, technology, financial services, or energy sectors.
Global Macro
Global macro is a style of hedge fund strategy that trades based upon macroeconomic or “top-down” analysis. Normally the securities are global stock index futures, bond futures, and currencies.
Short Selling
The short selling manager maintains a consistent net short exposure in his/her portfolio, meaning that significantly more capital supports short positions than is invested in long positions (if any is invested in long positions at all). Unlike long positions, which one expects to rise in value, short positions are taken in those securities the manager anticipates will decrease in value. Short selling managers typically target overvalued stocks, characterized by prices they believe are too high given the fundamentals of the underlying companies.
Emerging Markets
Emerging market investing involves investing in securities issued by businesses and/or governments of countries with less developed economies that have the potential for significant future growth.
Merger Arbitrage
Merger arbitrage involves the investing of event-driven situations of corporations; examples are leveraged buy-outs, mergers, and hostile takeovers. Managers purchase stock in the firm being taken over and, in some situations, sell short the stock of the acquiring company.
Value-Driven
Value-driven is a primarily equity-based strategy whereby the manager compares the price of a security relative to the intrinsic worth of the underlying business. The manager often selects stocks for which he or she can identify a potential upcoming event that will result in the stock price changing to more accurately reflect the company’s intrinsic worth.
Multi-Strategy
A multi-strategy manager typically utilizes two or three specific, predetermined investment strategies (e.g., value, aggressive growth, and special situations). This gives the investor access to multiple strategies with one investment. These funds also allow the manager to shift between strategies so that she can make the most money. This is similar to a situation in which a merger arbitrage manager left her investment mandate broad enough so that she could invest in distressed debt if the opportunity arose. Multi-strategy funds can offset some of the risk of one strategy doing poorly by employing other strategies simultaneously.
Fund of Hedge Funds (Fund of Funds)
A fund of hedge funds is also a hedge fund. This strategy invests in other hedge funds, which in turn utilize a variety of investment styles. A fund of funds takes investments from various investors and invests the money into a variety of different hedge funds. This allows for diversification of strategies and markets and increased chance of positive returns with low risk. Like other hedge funds, funds of funds are organized as onshore or offshore entities that are a limited partnership or corporations with the general partner receiving the management and/or performance fee. Funds of funds can offer an effective way for an investor to gain exposure to a range of hedge funds and strategies without having to commit substantial assets or resources to the specific asset allocation, portfolio construction, and individual hedge fund selection. The objective is to smooth out the potential inconsistency of the returns from having all of the assets invested in a single hedge fund. A growing number of style or category specific funds of funds have been launched during the past decade; for example, funds of funds that invest only in event-driven managers or funds of funds that invest only in equity market neutral style managers. This allocation creates a diverse vehicle and provides investors with access to managers that they may not be able to utilize on their own. A particular benefit of this type of investment is the ability to establish a diversified alternative investment program at a substantially lower minimum investment than would be required were an investor to invest with each of the hedge fund managers separately.