Top 10 Hedge Funds Strategies

Hedge funds, like mutual funds, also manage pooled money. However, there are some important differences. Mutual funds largely cater to retail savers while hedge funds cater to high risk HNIs and institutions. Hedge funds have more flexibility in taking risk and creating structures. Hedge funds are also less regulated compared to mutual funds. Post the financial crisis of 2008, hedge funds have lost a lot of incremental money to passive strategies and ETFs. Here is a look at 10 interesting hedge fund strategies.

1. Hybrids or long/short equity

Long/short equity strategy entails simultaneously taking long and short positions in equity or equity derivatives. Such long short strategies can be fundamental, technical or quantitative. For example, hedge funds can do long short when they expect a stock or sector to outperform another stock or sector. Long short strategies are also employed when hedge fund expect mean reversion of ratios e.g. gold/silver ratio. Unlike mutual funds, hedge funds do not allow seamless entry and exit and the minimum barrier is also quite high. That is what enables such complex strategies.

2. Credit risk strategies

As the name suggests, such strategies normally entail going down the rating curve. For example, if an AA rated bond is as safe as an AAA rated bond but if yields are nearly 100 basis points higher, then it gives scope for credit risk strategies. Hedge funds make the best of such pricing inefficiencies. Credit risk hedge funds are normally active in downturns.

.Vulture funds and distressed debt

This is a subset of credit risk strategies but is a lot more specialised and has a lot of legal nuances to it. When a company is unable to meet its financial obligations or is in a liquidity crisis (some PSU banks in India and NBFCs), its debt devalues. Vulture funds use fundamental analysis to identify undervalued investments. Such funds normally entail a long lock-in period considering their unique nature.

Fixed Income Arbitrage

An arbitrage is all about exploiting price differentials due to market related pricing inefficiencies. A simple example is if yields on the short end of the yield curve are higher than yields at the long end. It should actually be the other way round as longer tenure means higher risk. Such situations give rise to fixed income arbitrage. Fixed income arbitrage strategies include yield curve arbitrage and capital structure arbitrage.

Arbitrage on convertibles

Let take the example of a fully convertible debenture (FCD) or a partially convertible debenture (PCD). Such convertibles come with an embedded option to convert the FCD/PCD into a certain number of shares at a pre-determined price. If the valuation of the company has changed, then such convertibles can become extremely valuable. Convertible arbitrage involves taking long positions in a company’s convertible securities while simultaneously taking a short position in stock futures. It seeks to profit from price inefficiencies of a company’s convertible securities relative to the stock.

6. Arbitrage on relative value

This is a high risk strategy often employed by hedge funds in India and abroad. In India, this is also popularly called pair trading. It takes advantage of perceived price discrepancies between highly correlated investments or deviations from long term mean correlations. Typically, relative value arbitrage strategies involve high risk because it can backfire both ways and losses can magnify. Hence strict stop losses and in-depth expertise is a must.

7. Corporate event driven strategies

These strategies seek to exploit stock price changes that may occur due to specific corporate actions like mergers, takeovers, reorganisations, restructuring, asset sales, spin-offs, dividend declarations etc. Event-driven strategies require expertise in modelling and make extensive use of simulation and artificial intelligence.

8. Quant as a strategy

Quantitative hedge fund strategies rely on quantitative analysis to make investment decisions. Such hedge fund strategies typically utilise technology-based algorithmic to achieve desired investment objectives. Quantitative strategies are often referred to as “black box” funds since investors ordinarily have limited access to investment strategy specifics. Such strategies are normally proprietary and use low latency execution.

9. Global macro strategy

Global macro refers to making investment decisions based on broad political and economic shifts in various countries. This includes bets on shifts in GDP growth, shifts in inflation, changes in interest and yields, major shifts in currency value etc. Classic cases are trades in the financial crisis 2008, European crisis 2011 and Asian crisis 1998.

10. Multi strategy approach

In a nutshell, this is an amalgam of few or many of the above strategies. It offers a lot more flexibility to the hedge fund manager. Multi-strategy funds tend to have low-risk tolerance and lay a lot of emphasis on capital preservation

In reality there are scores of sub-strategies but hedge funds broadly operate within any of the above classifications.