Types of Hedge Funds

While traditional funds only concern themselves with stocks and bonds primarily, with only a small percentage going beyond that and perhaps getting into things like precious metals on the long side, hedge funds are not limited to this and can invest in pretty much anything and in pretty much any fashion imaginable.

In spite of what many investors may think, hedge funds aren’t really primarily concerned with taking on additional risks, they generally will do quite the opposite, and use their additional powers so to speak to primarily manage risk, to hedge more in other words.

Types of Hedge FundsWhen the stock market is booming, normal funds will generally beat hedge funds in returns, those who are comprised of positions that are long the stock market, stock market index funds or those whose funds hold a basket of selected stocks.

Stocks can run pretty well in a bull market, and stock indexes really aren’t hedged at all, not in a meaningful way at least. Funds may look to diversify their stock positions but we’re talking about market moves here, where stocks rise and fall to a large degree in tandem, so if you are 100% in stocks you have no hedging against market risk.

Hedge funds, on the other hand, are hedged, and their primary directive is toward hedging. These hedges with hedge funds that have positions in the stock market will have their hedges mute returns during a big move upward, but when things are more stagnant or move in the other direction, this is where hedge funds tend to shine more, because they look to seek positive returns regardless of the market climate.

This is the biggest difference between hedge funds and mutual funds, where the performance of mutual funds depends upon the market, where you’re hoping for it to advance and not decline. Hedge funds depend less upon market conditions, regardless of their strategy, and there are indeed a lot of strategies that hedge funds pursue to look to achieve their goals.

What hedge funds seek to do is to adapt themselves better to the market rather than allowing the market to dictate their performance, and how they accomplish this does vary a lot among the different types of hedge funds, but all of them have their primary goal to control their own destiny more rather than just relying on hope.

Market Neutral Hedge Funds

Market neutral hedge funds look to capitalize in a similar way regardless of market conditions, where other strategies may benefit more or less from how the market is performing, including both the long only strategies that mutual funds use and to a lesser degree the mixed long-short approach that many hedge funds employ.

Arbitrage comprises at least a part of this approach, and arbitrage is as market neutral as you can get, because the trend here doesn’t matter at all. Whether something is going up or down is actually immaterial, as you are just looking to trade differences in price here.

Market neutral funds also employ a variety of other sophisticated techniques and strategies to seek to achieve their goals, and some of these will involve actual trading, taking long and short positions in things like derivatives to look to benefit from a trading advantage that may be present.

Arbitrage is well beyond the means of individual investors as it requires huge amounts of capital and leverage together with cutting edge quantitative analysis. Arbitrage involves taking advantage of differences in price between the same or comparable assets, where the arbitrageur looks to take advantage of these very small differences by trading them.

Arbitrage in general performs a very important function in markets. For example, if you are looking to trade options, you want the price of the options to be in line with the price of the asset. If not, you are not getting the right price.

If the price of one or the other gets out of line, arbitrageurs step in and benefit, and it doesn’t take much of a price imbalance to attract them. This is thanks in large part to leverage, and these positions are very low risk so this is one of the cases where a very high amount of leverage can be used fairly safely.

If we are highly leveraged, then it doesn’t take much of a difference at all in price for us to profit, and this has the effect of making markets more efficient. If the price of something is only a little tiny bit off in one market compared to another, people will step in and buy it in the cheaper market and sell it in the higher priced one and this will serve to bring the prices between the two markets extremely close, to the point where the differences cannot be capitalized on even with high leverage.

Some hedge funds specialize in arbitrage, and while this may not be all that exciting, the goal here is to manage risk, not return, and the risk to return ratio of arbitrage directed hedge funds can be enticing to those who desire very conservative approaches that still provide returns that are desirable to them.

It is not that market neutral funds are risk free, and funds can still overexpose themselves to significant risk by making poor decisions, as the high leverage can greatly amplify these mistakes. Therefore, while this approach can be on the conservative side, it is so only in the right hands.

Long-Short Hedge Funds

A lot of hedge funds operate similar to the way mutual funds do, taking positions in markets such as stocks or bonds, although in the case of hedge funds they have the ability to go either long or short their investments and look to take advantage of market trends this way.

Hedge funds not only trade long and short in stocks and bonds though, they are free to choose virtually any financial asset to do this with, which makes them more flexible as well over mutual funds.

If we are in a bull market for instance, it pays to be on the long side, but in a bear market, it does not. If one can go short in a bear market though, this can be a huge advantage, and while most investors are losing money, you can be one of the people who are taking it from them if you are short during these times.

The trick of course is to determine which type of market we’re in, but this is actually not all that difficult, especially with the medium range terms that funds tend to look at. It’s of course much easier to determine this after the fact, but it’s not really that hard to tell what direction the market is moving broadly, and although nothing moves straight up or down, there are clear trends that emerge.

If we look at the overall stock market trend between 2009-2018, we do see a clear upward trend, and there are other times where we see a clear downward trend in bear markets. Long –short hedge funds look to ride the trend, which may concern itself either with overall trends of the stock market or trends of individual stocks or sectors of stocks.

This type of hedge fund tends to be the best performing, and although there is certainly risk involved, there is considerably less risk than just going with the long side and exposing yourself to the full risk of the market. Individuals encounter the risk of making too many mistakes if they do this without the right amount of skill, but hedge funds employ people of real talent who are far less prone to these mistakes.

Long-short approaches can be easily benchmarked with both indexes and pure long funds, and when we compare, we see that long-short hedge funds both increase returns and manage risk better than these long only funds overall, which should be no surprise given the strategic advantages that long-short funds enjoy.

The biggest difference between the two types of funds isn’t performance though, it’s risk management, although sound risk management is really the hallmark of success overall with investing.

Included in the long-short category are what are termed global macro funds, which makes their bets on movements in economic trends, versus those that may affect only a certain sector or certain investments.

Global macro funds take long and short positions in things like bonds, currency, and derivatives, and therefore their approach can be considered among the long-short category, and long-short hedge funds will often use a number of different approaches and trade a variety of different instruments to achieve their objectives.

Event Driven Hedge Funds

While long-short funds focus a lot on the technical aspects of markets, looking to capitalize on trends, event driven hedge funds take a more fundamental approach, but not the same type that investors tend to take.

Rather, the fundamentals that event driven funds look to profit from are things like trading distressed companies or companies that are involved in takeovers, restructuring, mergers, and the like.

While arbitrage approaches price inefficiencies from a technical standpoint, event driven funds look to arbitrage fundamental inefficiencies, where the price of something may not be in line with what the security should be worth or may be worth when the dust settles so to speak.

When a company is beaten up badly for instance, but still has enough promise, an event driven hedge fund may step in and buy a substantial amount of it, seemingly coming to its rescue, but the intent is not to rescue the but to profit from the expected turnaround.

There are also instances where a company is changing its structure, for instance merging with another, and the market may not price its stock in line with where it should be when all the considerations involved are accounted for. Hedge funds will once again step in on the side of value here and arbitrage the changes so to speak.

Needless to say, this is not a low risk strategy, but the benefits when you are right on these moves can be pretty substantial indeed. To pull this off, you do need world class analysis, but these event driven hedge funds do have that and do look to leverage these talents.

One can choose a type of hedge fund to invest in, or one may instead look to seek maximum diversity and invest in hedge funds of funds, which spread things around and is sort of an index of hedge funds like the S&P 500 is an index of large cap stocks.

This approach is particularly appealing to a lot of individual investors who have little knowledge of the workings of some or all of these funds, and may not understand them well enough to want to select one type over another, and can make this decision easy by just going with a fund that encompasses all of these strategies.

Hedge funds are certainly interesting and while we never want to say that hedge funds are always better than mutual funds, they often do provide superior performance overall, but this all really depends on selecting both the right types and the right funds within a given type in order to seek out the best investment situation for us.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: eric@marketreview.com

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.