Ever consider investing in a hedge fund? As a first step, potential investors need to know how these funds make money and how much risk they take. While no two funds are identical, most generate their returns from one or more of the following strategies:

  1. Long/Short Equity

The first hedge fund - launched by Alfred W. Jones in 1949 - used a long/short equity strategy, which still accounts for the lion’s share of equity hedge fund assets today. The concept is simple: Investment research turns up expected winners and losers, so why not bet on both? Pledge long positions in the winners as collateral to finance short positions in the losers. The combined portfolio creates more opportunities for idiosyncratic (i.e. stock-specific) gains, and reduces market risk because the shorts offset long market exposure.

In essence, long/short equity is an extension of pairs trading, in which investors go long and short two competing companies in the same industry based on their relative valuations. If General Motors (GM) looks cheap relative to Ford, for example, a pairs trader might buy $100,000 worth of GM and short an equal value of Ford shares. The net market exposure is zero, but if GM does outperform Ford, the investor will make money no matter what happens to the overall market. Suppose Ford rises 20% and GM rises 27%; the trader sells GM for $127,000, covers the Ford short for $120,000 and pockets $7,000. If Ford falls 30% and GM falls 23%, he sells GM for $77,000, covers the Ford short for $70,000, and still pockets $7,000. If the trader is wrong and Ford outperforms GM, however, he will lose money.

Long/short equity is a relatively low-risk leveraged bet on the manager’s stock-picking skill.

  1. Market Neutral

Long/short equity hedge funds typically have net long market exposure, because most managers do not hedge their entire long market value with short positions. The portfolio's unhedged portion may fluctuate, introducing an element of market timing to the overall return. By contrast, market-neutral hedge funds target zero net-market exposure - i.e. shorts and longs have equal market value, which means the managers generate their entire return from stock selection. This strategy has a lower risk than a long-biased strategy - but the expected returns are lower, too.

Long/short and market-neutral hedge funds struggled for several years after the 2007 financial crisis. Investor attitudes were often binary: risk-on (bullish) or risk-off (bearish) - and when stocks go up or down in unison, strategies that depend on stock selection don’t work. In addition, record-low interest rates eliminated earnings from the stock loan rebate, or interest earned on cash collateral posted against borrowed stock sold short. The cash is lent out overnight, and the lending broker keeps a proportion - typically 20% of the interest - as a fee for arranging the stock loan and "rebates" the remaining interest to the borrower (to whom the cash belongs). If overnight interest rates are 4% and a market-neutral fund earns the typical 80% rebate, it will earn 0.04 x 0.8 = 3.2% per annum before fees, even if the portfolio is flat. But when rates are near zero, so is the rebate.

  1. Merger Arbitrage

A riskier version of market neutral called merger arbitrage derives its returns from takeover activity. After a share-exchange transaction is announced, the hedge fund manager may buy shares in the target company and sell short buyer shares in the ratio prescribed by the merger agreement. The deal is subject to certain conditions - regulatory approval, a favorable vote by target company shareholders and no material adverse change in the target’s business or financial position, for example. The target company shares trade for less than the merger consideration's per-share value, a spread that compensates the investor for the risk that the transaction may not close and for the time value of money until closing.

In cash transactions, target company shares trade at a discount to the cash payable at closing so the manager does not need to hedge. In either case, the spread delivers a return when the deal goes through no matter what happens to the market. The catch? The buyer often pays a big premium over the pre-deal stock price, so investors face large losses when transactions fall apart.

  1. Convertible Arbitrage

Convertibles are hybrid securities that combine a straight bond with an equity option. A convertible arbitrage hedge fund is typically long convertible bonds and short a proportion of the shares into which they convert. Managers try to maintain a delta-neutral position in which the bond and stock positions offset each other as the market fluctuates. To preserve delta-neutrality, traders must increase their hedge - i.e. sell more shares short if the price goes up and buy shares back to reduce the hedge if the price goes down, forcing them to buy low and sell high.

Convertible arbitrage thrives on volatility. The more the shares bounce around, the more opportunities arise to adjust the delta-neutral hedge and book trading profits. Funds thrive when volatility is high or declining but struggle when volatility spikes - as it always does in times of market stress. Convertible arbitrage faces event risk, too: If an issuer becomes a takeover target, the conversion premium collapses before the manager can adjust the hedge, inflicting a significant loss.

  1. Event Driven

On the border between equity and fixed income lie event-driven strategies, in which hedge funds buy the debt of companies that are in financial distress or have already filed for bankruptcy. Managers often focus on the senior debt, which is most likely to be repaid at par or with the smallest haircut in any reorganization plan. If the company has not yet filed for bankruptcy, the manager may sell short equity, betting the shares will fall either when it does file or when a negotiated equity for debt swap forestalls bankruptcy. If the company is already in bankruptcy, a junior class of debt entitled to a lower recovery upon reorganization may be a better hedge.

Investors in event-driven funds have to be patient. Corporate reorganizations play out over months or even years, during which the troubled company’s operations may deteriorate. Changing financial-market conditions can also affect the outcome - for better or worse.

  1. Credit

Capital structure arbitrage, similar to event-driven trades, underlies most hedge fund credit strategies, too. Managers look for relative value between senior and junior securities of the same corporate issuer. They also trade securities of equivalent credit quality from different corporate issuers, or different tranches in the complex capital of structured debt vehicles like mortgage-backed securities or collateralized loan obligations. Credit hedge funds focus on credit rather than interest rates; indeed, many managers sell short interest rate futures or Treasury bonds to hedge their rate exposure.

Credit funds tend to prosper when credit spreads narrow during robust economic growth periods but may suffer losses when the economy slows and spreads blow out.

  1. Fixed-Income Arbitrage

Hedge funds that engage in fixed-income arbitrage eke out returns from risk-free government bonds, eliminating credit risk. Managers make leveraged bets on how the shape of the yield curve will change. For example, if they expect long rates to rise relative to short rates, they will sell short long-dated bonds or bond futures and buy short-dated securities or interest rate futures.

These funds typically use high leverage to boost what would otherwise be modest returns. By definition, leverage increases the risk of loss when the manager is wrong.

  1. Global Macro

Some hedge funds analyze how macroeconomic trends will affect interest rates, currencies, commodities or equities around the world and take long or short positions in whichever asset class is most sensitive to their views. Although global macro funds can trade almost anything, managers usually prefer highly liquid instruments like futures and currency forwards.

Macro funds don’t always hedge, however - managers often take big directional bets, which sometimes don’t pan out. As a result, returns are among the most volatile of any hedge fund strategy.

  1. Short Only

The ultimate directional traders are short-only hedge funds, the professional pessimists who devote their energy to finding overvalued stocks. They scour financial statement footnotes and talk to suppliers or competitors to unearth signs of trouble investors are ignoring. Occasionally managers score a home run when they uncover accounting fraud or other malfeasance.

Short-only funds can provide a portfolio hedge against bear markets, but they are not for the faint of heart. Managers face a permanent handicap: they must overcome the long-term upward bias in the equity market.

The Bottom Line

Investors should conduct extensive due diligence before they commit money to any hedge fund, but understanding which strategies the fund uses and its risk profile is an essential first step.

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