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6 Common hedge fund trading strategies
The bottom line
Jul 22, 2022
7 min read
Hedge funds use a variety of strategies to generate profits, they can aid diversification and lower the risk inherent in the stock, bond, and other markets.
Wall Street historians credit Alfred Winslow Jones, a former Fortune magazine writer, with creating the first hedge fund, A.W. Jones & Co., in 1949. The fund had characteristics distinguishing it from other investment funds of the time.
It used leverage, or borrowed money, to amplify returns. And the fund wagered that particular stocks would fall, and others would rise, meaning performance wouldn’t simply track the overall market. The fund would serve as a “hedge,” or a way to reduce risk of losses.
The lure for Jones himself was the fund’s distinctive compensation structure—he paid himself a 20% cut of investment gains as a performance fee. This became the second half of the “2 and 20” hedge fund compensation structure—managers often received a fee equal to 2% of the assets under management and 20% of the profits.
The success of early hedge funds led to a flood of money from institutional investors and wealthy individuals, spurring the creation of thousands of funds. Assets under management ballooned from $491 billion in 2000 managed by more than 3,000 U.S. funds to $4 trillion in assets managed by more than 8,000 funds as of 2022, using a wide range of strategies—from the simple to by zantine.
Hedge funds generally rely on one of six overarching investment strategies, though there is a wide array of subcategories within these groupings.
Sometimes called “equity hedge,” these funds in their simplest form might buy ExxonMobil stock and short sell Chevron shares, anticipating a rise in the former and a decline in the latter. There are various iterations of the basic long-short position, however, including:
. The most classic variety of long-short strategies is the equity neutral fund. As was the case with A.W. Jones, the goal of a market neutral fund is to calibrate bullish and bearish bets so that overall positioning of the portfolio allows it to perform well in up markets or down.
. These strategies are similar to the equity market neutral approach, but focus on their respective universes of stocks—fast growing growth stocks or cheaper value stocks. Accordingly, depending on their orientation, the funds buy shares of companies with greater earnings growth potential and short those with less or, alternatively, buy less expensive stocks and short pricier ones.
. These funds focus almost exclusively on short selling stocks or other asset classes, expecting to profit when prices fall. Because stocks and other assets tend to rise over time, institutions use these funds as complements to their long positions. Noted short sellers like James Chanos, who manages the hedge fund Kynikos Associates, gained notoriety by uncovering frauds, such as the now-defunct energy trader Enron in 2002.
Managers identify mispricings of related securities, such as bonds issued by the same company but of differing maturities, shorting the overpriced ones and buying the cheaper ones. These funds exploit a number of different strategies including:
. A fund manager might buy 20-year Coca-Cola bonds, for example, and sell short the company’s five-year bonds. The fund would profit if the 20-year bond appreciated more than its shorter-term counterpart. Saba Capital Management is a good example of a credit fund that utilizes a range of bonds, exchange-traded funds (ETFs), swaps, and other derivatives.
. Interest-bearing convertible bonds allow their holders to exchange them for stock in the company at a set price at some time in the future. At its simplest, convertible arbitrage is buying a convertible bond and shorting the appropriate amount of stock in hopes of locking in a relatively risk-free yield. Because the convertible bond market is of a modest size, convertible arbitrage funds are constrained by how big they can grow.
. By using options and sophisticated hedging techniques, hedge fund managers can wager on whether price moves in stock or bond indexes, such as the Standard & Poor’s 500 Index, vary more or less than the market expects. Accordingly, they may make money if stocks move sharply up or down. Doing so often generates returns that are not necessarily correlated to the market’s overall direction—a goal for most hedge fund investors.
Event-driven hedge funds make bets anticipating corporate developments such as quarterly earnings surprises, mergers, restructurings, and dividend hikes. They often balance out bullish bets on anticipated developments by hedging with a short wager using industry-focused ETFs. These funds often rely on the following strategies:
. The provocateurs of the hedge fund world, these managers accumulate a position in a company and then agitate for corporate change, such as ousting management, increasing dividends or share buybacks, or selling a division or the whole company. Famous practitioners include Dan Loeb of Third Point and Carl Icahn.
. Known as the vultures of Wall Street, these hedge funds specialize in distressed securities and buy up the stocks or bonds of troubled companies, often when they are in Chapter 11 bankruptcy and attempting to reorganize. These funds often get representation on the creditors committee, enabling them to stake out big equity positions when the restructured company exits bankruptcy. Appaloosa Management and Litespeed Management have both made names for themselves with distressed investments.
. When one company announces its plans to merge with another, the target’s share price usually rises and the acquirer’s falls. But the target’s shares usually don’t hit the takeover price at first—there is too much uncertainty that the deal won’t close. The merger arbitrage manager assesses the likelihood of a deal being completed and invests accordingly, often buying the target’s shares and shorting those of the acquirer. Oscar Gruss and Kelner DiLeo are two firms specializing in this niche.
Sometimes called simply macro, these fund managers speculate on global economic and political trends by investing in a variety of futures and other markets. If the price of oil falls, for example, it might make sense to count on a decline in the value of Norway's currency (the kroner), which is tied to oil prices. Meanwhile, the other side of the strategy might be to buy the government bonds of Germany, whose economy benefits from cheaper energy. The two markets these funds often focus on are:
. Although many global macro firms trade a variety of instruments, including equity and bond indexes and derivatives (contracts based on the value of some other asset or security), some have carved out expertise in the foreign exchange market, the most liquid in the world. Factors influencing currencies include central bank actions, trade data, political events like elections or wars, and interest rates. Soros Funds Management, Bridgewater Associates, and Brevan Howard Asset Management are three of the more successful currency focused firms.
. Some global macro hedge funds focus on commodities markets, betting on the supply and demand for oil, gold, cotton, wheat, and pork bellies. Because of the ease of trading them, hedge funds tend to buy commodities using futures rather than on the spot market.
Quantitative investors, or quants for short, use proprietary, mathematical formulas and massive computer power to uncover patterns in the movements of stocks, bonds, or other asset classes that are used to generate profits through quick, automated trading. Patterns come in two general varieties: A trend following pattern might dictate that a bond that rises five days in a row will likely rise a sixth day as well. On the other hand, a reversionary pattern predicts that a stock price that closes sharply higher one day will usually open lower the next. Notable quants include Jim Simons of Renaissance Technologies and Peter Muller of PDT Partners.
Most big hedge fund firms, those with more than $5 billion in assets, use more than one strategy. The strategies might be combined within a single fund or they may be placed in independent funds. Multi-strategy hedge funds include David Shaw’s D.E. Shaw & Co. and Israel Englander’s Millennium Management.
Hedge funds use a variety of strategies to generate profits, ranging from dedicated short-selling to merger arbitrage to global macro. Taken together, despite their reputation for volatile returns, hedge funds can aid diversification and lower the risk inherent in the stock, bond, and other markets, making them a useful tool for institutional investors and wealthy individuals.
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