Fifteen primary strategies describe the major investment theme or methodology that the hedge fund manager employs to govern the portfolio assembly process. These strategies are rolled up to five broad categories.
Equity hedging strategies are used by managers who primarily build portfolios by selecting some proportion of long and short holdings of common stocks. Managers may also use options to gain leveraged equity positions or to hedge positions. Most managers primarily assemble portfolios using fundamental research, although some managers may employ top-down strategies.
Equity Net Long Exposure involves maintaining a core group of long holdings while hedging these positions at all times with short positions. The manager typically attempts to profit from the relative outperformance of long positions against these short positions. The fund manager may focus on a specific sector or geographic area based on available opportunities and management expertise. Typically, the ratio of long to short holdings should fall into the range of 60/40 to 85/15.
Equity Net Neutral funds attempt to limit vulnerability to market movements by utilizing both long and short positions. Diversification is a must for this strategy to be effective. Short positions are used to hedge much of the systematic risk in the long positions on either a dollar or beta adjusted basis. Equity Net Neutral funds often seek profit by attempting to exploit pricing inefficiencies between related equity securities. An example of this strategy is building a portfolio containing long positions in the strongest companies of several industries and taking short positions in companies showing signs of weakness in the corresponding industries. The ratio of long to short holdings should consistently be in the 60/40 to 40/60 range.
This strategy combines long positions with short sales to achieve the desired return. Managers attempt to offset market risk by taking advantage of anticipated market declines. This type of investment style seeks to maintain a net short exposure to the market. Typically the ratio of long to short holdings is between 40/60 and 15/85, although some managers may go 100% short.
Equity Variable Exposure funds utilize both long and short positions but do not attempt to maintain a directional bias; net market exposure is adjustable. The net exposure for these funds varies widely from 80% long to 80% short given the manager's overall equity market sentiment.
4Linked Security Arbitrage Strategies
Managers employing arbitrage strategies between two or more securities that the manager believes are mis-priced relative to each other, and that will return to equilibrium at some point in the future. Normally, the manager takes a long position in the under-priced security and a short position in the over-priced security and holds the positions until after the arbitrage opportunity no longer exists.
Convertible Arbitrage funds attempt to exploit pricing differences between various convertible securities. Because this amount is often very small, many of these funds employ leverage to maximize return. Convertible Arbitrage managers are exposed to the volatility and/or credit risk of the bond, while they generally hedge the default risk by shorting shares in the company's stock. This strategy is typically market neutral.
Fixed Income Arbitrage funds attempt to exploit pricing inefficiency among various types of fixed income instruments while neutralizing exposure to interest rate risk. The typical types of fixed income hedging strategies include, but are not limited to, the following: yield-curve, corporate versus treasury yield spreads, municipal bond versus treasury yield spreads, and cash versus futures.
Relative Value Arbitrage comprises those funds that practice a strategy in which a money manager attempts to capture a perceived spread between any two securities. Some examples include capital structure arbitrage, statistical arbitrage, dividend arbitrage, or pairs trading.
4Corporate Life Cycle Strategies
Corporate life cycle strategies attempt to take advantage of events that occur during the lifetime of a company and that may have a material impact on the prices of its related securities at some time in the future. These events include bankruptcy and emerging from bankruptcy, mergers, stock buybacks, spin-offs or divestitures, dividend issuance, major strategy shifts, and other non-normal events. Managers typically try to hedge market exposure by shorting stock or by using futures and options to capture the price change related to the event itself, and not overall market conditions.
Corporate Event Driven funds seek profit from a broad range of corporate events. Examples of transactional events that a fund manager may attempt to exploit include spin-offs, mergers and acquisitions, bankruptcies, recapitalizations, and share buybacks. Strategies may involve purchases of different elements of a company's capital structure, such as preferred stocks, options, or convertibles.
Distressed Company funds invest in securities of financially troubled companies which could be involved in bankruptcies, distressed sales, corporate restructurings and/or financial reorganizations. Depending on the manager's style, investments may be made in bank debt, corporate debt, trade claims, common stock, preferred stock, and warrants.
The Merger Arbitrage strategy involves taking positions in companies that are either currently or likely to be involved in corporate mergers and acquisitions (including peaceful mergers, leveraged buy-outs, and hostile takeovers). Merger Arbitrage funds typically purchase shares in the company about to be taken over while selling shares in the acquiring company. Managers may use equity options as a low-risk alternative to the outright purchase or sale of common stock. Most Merger Arbitrage funds hedge against market risk by purchasing broad market index put options (e.g. S&P 500) or put option spreads.
4Macroeconomic Trend Investment Strategies
Macroeconomic Trend Investment Strategy funds attempt to invest according to broad-based changes in global markets. Often these strategies include global tactical asset allocation bets and utilize equities, bonds, currency contracts, futures contracts, and other derivatives. Many managers look for trends within and among various countries, industries, and geopolitical institutions. Some managers attempt to detect emerging trends or exploit market volatility in times of uncertainty.
Emerging Markets funds invest in equity and fixed income securities offered by corporations and governments in developing nations. Emerging markets strategy managers consider the macroeconomic trends and industry developments affecting these countries while also evaluating political, government, majority shareholder, and currency risks. Examples of regions pursued for this strategy include Latin America, Eastern Europe, the former Soviet Union, Africa, and parts of Asia.
Global Macro funds hold both long and short positions in currencies, bonds, equities, and commodities. Investment decisions are made by taking a top-down or broad view of the global economy, government policies, interest rates, inflation, and various other market dynamics. The manager may also base investment decisions on relative valuations of financial instruments within or between asset classes.
Managed Futures funds take long and short positions in liquid financial futures such as currencies, interest rates, stock market indices, and commodities. Managed Futures managers typically base investment decisions on strict quantitative methods, notably, trend-following models.
Multi Strategy funds are those which do not practice a single investment process to account for more than 80% of the fund's risk capital. Although gradual shifts may occur over time in response to economic or market trends, these funds tend to have relatively stable allocations.
Fund of Funds refers to a hedge fund which maintains a collection of other hedge funds as its portfolio.