CFA Level 1

By Investopedia AAA

Alternative Investments - Hedge Fund Classifications

  • Long/Short - This is the traditional type of hedge fund. Its strategy involves buying certain stocks long and selling others short. There usually isn't a restriction on the country in which the stocks must be traded. Long/short funds use leverage and adjust "net" long or short positions based on economic forecasting.
  • Market-neutral funds - A hedge fund strategy that seeks to exploit differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, etc. This strategy creates a hedge against market factors. Long positions are viewed as undervalued while short are overvalued. These funds tend to use leverage.

    This is the ultimate strategy for stock pickers because stock picking is all that counts. For example, a hedge fund manager will go long in the 10 biotech stocks that should outperform and short the 10 biotech stocks that will underperform. Therefore, what the actual market does won't matter (much) because the gains and losses will offset each other. If the sector moves in one direction or the other, a gain on the long stock is offset by a loss on the short.
  • Global macro fund - A hedge fund strategy that bases its holdings - such as long and short positions in various equity, fixed income, currency and futures markets - primarily on overall economic and political views of various countries (macroeconomic principles). For example, if a manager believes that the U.S. is headed into recession, he or she might short sell stocks and futures contracts on major U.S. indexes or the U.S. dollar. Or, a manager who sees a big opportunity for growth in Singapore might take long positions in Singapore's assets.
  • Futures fund (managed future fund) - Commodity pools that include commodity trading advisor funds (CTA). These funds take direction bets in the positions they hold in a single asset class such as currencies and interest rates or commodities.
  • Emerging-market fund - A mutual fund that invests a majority of its assets in the financial markets of a developing country, typically a small market with a short operating history. These markets tend to be less liquid and efficient than developed markets. They are fairly volatile and are influenced by economic and political factors.
  • Event Driven - A hedge fund strategy in which the manager takes significant positions in a certain number of companies in "special situations."

    This includes:
    • Distressed securities funds - Invest in debt or equity of companies with severe problems and that are in or close to bankruptcy. The fund manager takes a long position in such companies when he believes that the company can turn around its situation and achieve profitability. He takes a short position if he believes the company will ultimately fail.
    • Risk arbitrage in mergers and acquisitions - The technique takes advantage of price differences that usually exist between the current market price of the shares of a company that is being acquired and the stock price of the acquiring company. The company being taken over will tend to trade up in price while the company acquiring the other firm will tend to decrease in value. The risk is that the merger will fail and each stock will revert back it its original level.


Distressed Securities Investing
Distressed securities are stocks, bonds and trade or financial claims of companies in, or about to enter or exit, bankruptcy or financial distress or that are seeking to restructure themselves outside of court. Perhaps a company over-expanded or it is in debt as a result of a lawsuit or natural disaster, or it's experiencing management problems. In these situations, the prices of the company's securities falls in anticipation of the financial distress when its holders choose to sell rather than remain invested in a financially troubled company. Investment professionals, who understand the true risks and values of a company and can do detailed research, may be able to buy these securities or claims at discounted prices, from current owners who have overlooked or ignore the company's true worth.

Investing in distressed securities requires extensive legal, operational and financial analysis as well as an understanding that the bondholders have a superior claim on the company's assets. In fact, distressed investing usually takes place in the buying of the distressed company's debt securities.

A distressed opportunity typically arises when a company, unable to meet all of its debts, files for Chapter 11 (reorganization) or Chapter 7 (liquidation) bankruptcy. If a company files for Chapter 7, a company will cease operations and parcel out its assets to its creditors. Chapter 11 gives the company legal protection to continue operating while working out a repayment plan, known as a plan for reorganization, with its major creditors, including bondholders, banks, utilities and major vendors. When a company's assets are not sufficient to repay all claims, the stockholders (the last of the stakeholders to be paid) are unlikely to get any of the proceeds from the liquidation or reorganization. Therefore, investors in distressed securities focus mostly on acquiring the company's bonds, bank debt or even trade claims.

Companies in critical situations are motivated to sell to distressed securities investors because traditional institutional investors, like pension funds, are barred from holding below investment-grade bonds ('BBB' or lower). Banks are eager to sell their bad loans in order to remove them from their books and vendors or other holders of trade claims have no expertise or interest in assessing the likelihood of getting paid once a company has filed for Chapter 11. In short, when companies get into financial trouble, there is usually the opportunity to buy at steep discounts from people to whom money is owed.

This type of investing is similar to venture capital because both types of investing are performed with the hopes that the company will eventually turn a profit. In both scenarios, investors work with company management to reach the desired result.

Hedge Fund Risks and Performance

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