Hedge funds are alternative investments that use market opportunities to their advantage. These funds require a larger initial investment than others, and generally are accessible only to accredited investors. That's because hedge funds require far less regulation from the Securities and Exchange Commission (SEC) than others like mutual funds. Most hedge funds are illiquid, meaning investors need to keep their money invested for longer periods of time, and withdrawals tend to to happen only at certain periods of time.

As such, they use different strategies so their investors can earn active returns. But potential hedge fund investors need to understand how these funds make money and how much risk they take on when they buy into this financial product. While no two hedge funds are identical, most generate their returns using one or more of several specific strategies that we've outlined below.

Key Takeaways

  • Hedge funds are versatile investment vehicles that can use leverage, derivatives, and take short positions in stocks.
  • Because of this, hedge funds employ various strategies to try to generate active returns for their investors.
  • Hedge fund strategies range from long/short equity to market neutral.
  • Merger arbitrage is a kind of event-driven strategy, which can also involve distressed companies.

Long/Short Equity

The first hedge fund used a long/short equity strategy. Launched by Alfred W. Jones in 1949, this strategy is still in use on 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? Take 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, reducing market risk with the shorts offsetting long market exposure.

Long/short equity is basically an extension of pairs trading, in which investors go long and short on two competing companies in the same industry based on their relative valuations. It is a relatively low-risk leveraged bet on the manager’s stock-picking skill.

For example, if General Motors (GM) looks cheap relative to Ford, 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.

Let's 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.

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, or shorts and longs have an equal market value. This means 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). Besides, 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.

This typically amounts to 20% of the interest as a fee for arranging the stock loan, while "rebating" the remaining interest to the borrower. If overnight interest rates are 4% and a market-neutral fund earns the typical 80% rebate, it will earn 3.2% per annum (0.04 x 0.8) before fees, even if the portfolio is flat. But when rates are near zero, so is the rebate.

Merger Arbitrage

A riskier version of market neutral, merger arbitrage derives its returns from takeover activity. That's why it's often considered one kind of event-driven strategy. After a share-exchange transaction is announced, the hedge fund manager may buy shares in the target company and short sell the buying company's shares at the ratio prescribed by the merger agreement. The deal is subject to certain conditions:

  • Regulatory approval
  • A favorable vote by the target company's shareholders
  • No material adverse change in the target’s business or financial position

The target company's shares trade for less than the merger consideration's per-share value—a spread that compensates the investor for the risk of the transaction not closing, as well as 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 large premium over the pre-deal stock price, so investors face large losses when transactions fall apart.

Because merger arbitrage comes with uncertainty, hedge fund managers must fully evaluate these deals and accept the risks that come with this kind of strategy.

There is, of course, significant risk that comes with this kind of strategy. The merger may not go ahead as planned because of conditional requirements from one or both companies, or regulations may eventually prohibit the merger. Those who take part in this kind of strategy must, therefore, be fully knowledgeable about all the risks involved as well as the potential rewards.

Convertible Arbitrage

Convertibles are hybrid securities that combine a straight bond with an equity option. A convertible arbitrage hedge fund is typically long on convertible bonds and short on 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, or sell more shares short if the price goes up and buy shares back to reduce the hedge if the price goes down. This forces 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 as well. If an issuer becomes a takeover target, the conversion premium collapses before the manager can adjust the hedge, resulting in a significant loss.

Event-Driven

On the border between equity and fixed income lie event-driven strategies. This kind of strategy works well during periods of economic strength when corporate activity tends to be high. With an event-driven strategy, hedge funds buy the debt of companies that are in financial distress or have already filed for bankruptcy. Managers often focus on 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 that 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 constitute a better hedge.

Investors in event-driven funds need to be able to take on some risk and also be patient. Corporate reorganizations don't always happen the way managers plan, and, in some cases, the may 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 for worse.

Credit

Capital structure arbitrage, similar to event-driven trades, also underlies most hedge fund credit strategies. Managers look for a relative value between the 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 (MBSs) or collateralized loan obligations (CLOs). 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 they may suffer losses when the economy slows and spreads blow out.

Fixed-Income Arbitrage

Hedge funds that engage in fixed-income arbitrage eke out returns from risk-free government bonds, eliminating credit risk. Remember, investors who use arbitrage to buy assets or securities on one market, then sell them on a different market. Any profit investors make is a result of a discrepancy in price between the purchase and sale prices.

Managers, therefore, 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.

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 such as futures and currency forwards.

Macro funds don’t always hedge, but managers often take big directional bets—some never pan out. As a result, returns are among the most volatile of any hedge fund strategy.

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 any signs of trouble possibly ignored by investors. Hedge fund managers occasionally score a home run when they uncover accounting fraud or some 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.

Quantitative

Quantitative hedge fund strategies look to quantitative analysis (QA) to make investment decisions. QA is a technique that seeks to understand patterns using mathematical and statistical modeling, measurement, and research relying on large data sets. Quantitative hedge funds often leverage technology to crunch the numbers and automatically make trading decisions based on mathematical models or machine learning techniques. These funds may be considered "black boxes" since the internal workings are obscure and proprietary. High-frequency trading (HFT) firms that trade investor money would be examples of quantitative hedge funds.

The Bottom Line

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