Hedge Fund Strategies

Updated October 18, 2023

What are Hedge Fund Strategies?

You have to be intelligent to execute trading strategies to make Profits. This sentence usually goes for general trading activities. Trading hedge funds requires a high level of intelligence and expertise. It would be best to scour in and out for information about the Security, commodity, currency, and Swaps you are trading in.

But that was not the case with Jason. Jason is a hedge Fund Manager, but he is lacking at something. He has this dingy office with fading walls and spiderwebs everywhere. His office is now the dwelling place for rats, cats, hens, and raccoons. He has no idea how to apply the Hedge fund Strategy, nor does he have any Clients. People stare at him through his glass door and pity him.

But is this the end that we want for Jason’s career? Of course not! Let’s help him make better decisions regarding hedge fund strategy so that he and his clients can benefit. We can familiarize him with the various hedge fund strategies, allowing him to apply them and improve the situation. Before understanding the Hedge funds strategies, let’s give Jason some Fun, interesting facts about Hedge funds to build up some confidence.

• Alfred Winslow Jones founded the first hedge fund on Wall Street in 1949.
• Globally, there are more than 9,000 hedge funds.
• Hedge funds have almost  2 trillion USD in assets under management.
• The hedge fund market has doubled in size in the past five years.
• There is no global regulatory framework for them.

Having to know the facts, let’s understand the Hedge fund strategies in detail.

Long/Short Equity

• In this type of Hedge Fund Strategy, Investment managers maintain long and short positions in equity and equity derivative securities.
• Investors use a wide variety of techniques to arrive at an investment decision. It includes both quantitative and fundamental methods.
• Such strategies can be broadly diversified or narrowly focused on specific sectors.  It can range greatly in terms of exposure, leverage, holding period, concentrations of market capitalization, and valuations.
• The fund goes long and short in two competing companies in the same industry based on their relative valuations.
• However, most managers do not hedge their entire long market value with short positions.

Example

• If Tata Motors looks cheap relative to Hyundai, a trader might buy $100,000 worth of Tata Motors and short an equal value of Hyundai shares. The net market exposure is zero in such cases.
• But if Tata Motors does outperform Hyundai, the investor will make money no matter what happens to the overall market.
• Suppose Hyundai rises 20%, and Tata Motors grows 27%; the trader sells Tata Motors for $127,000, covers the Hyundai short for $120,000, and pockets $7,000.
• If Hyundai falls 30% and Tata Motors falls 23%, he sells Tata Motors for $77,000, covers the Hyundai short for $70,000, and still pockets $7,000.
• However, he will lose money if the trader is wrong and Hyundai outperforms Tata Motors.

Market Neutral

• By contrast, market-neutral hedge funds target zero net-market exposure, meaning that shorts and longs have equal market value.
•  In such a case, the managers generate their total return from stock selection. This strategy has a lower risk than the above strategy, but at the same time, the expected returns are also lower.

Example

• A fund manager may take a long position in the 10 biotech stocks expected to outperform and a short position in the 10 biotech stocks expected to underperform.
• Therefore, in such a case, the gains and losses will offset each other despite how the actual market does.
• In this scenario, the gain on the long stock is offset by a loss on the short supply, which balances out any movement in the sector.

Merger Arbitrage

• In such a hedge fund strategy, the hedge fund buys and sells the stocks of two merging companies simultaneously to create a riskless profit.
• This hedge fund strategy looks at the risk that the merger deal will not close on time or at all.
• Because of this small uncertainty, the target company’s stock will sell at a discount to the price that the combined entity will have when the merger is done. This difference is the arbitrageur’s profit.
• The merger arbitrageurs care only about the probability of the deal being approved and the time it will take to close it.

Example

Consider these two companies for this example – GNB Co. and Startles Co.

• Suppose GNB Co. is trading at $20 per share when Startles Co. comes along and bids $30 per share, a 25% premium.
• The stock of GNB will jump up but will soon settle at a price higher than $20 and less than $30 until the takeover deal is closed.
• Let’s say that the deal is expected to close at $30, and GNB stock is trading at $27.
• To take advantage of this price-gap opportunity, a risk arbitrageur would buy GNB at $28, pay a commission, hold the shares, and sell them for the agreed $30 acquisition price after closing the merger.
• Thus, the arbitrageur makes a profit of $2 per share, or a 4% gain, less the trading fees.

Convertible Arbitrage

• Convertibles generally are hybrid securities, including a combination of a bond with an equity option.
•  A convertible arbitrage hedge fund typically includes long convertible bonds and shorts a proportion of the shares they convert into.
• It includes a long position on bonds and a short position on common stock or shares.
• It attempts to exploit profits when a pricing error is made in the conversion factor, i.e., it aims to capitalize on mispricing between a convertible bond and its underlying stock.
• If the convertible bond is undervalued compared to the underlying stock, an arbitrageur will take a long position in the convertible bond and a short part in the store.
• If the convertible bond is overvalued compared to the underlying stock, the arbitrageur will buy the stock (take a long position) and sell the bond (take a short position).
• In such a strategy, managers try to maintain a delta-neutral position so that the bond and stock positions offset each other as the market fluctuates.
• Convertible arbitrage generally thrives on volatility. The reason is that the more the shares bounce, the more opportunities arise to adjust the delta-neutral hedge and book trading profits.

Example

• Visions Co. issues a 1-year bond with a 5% coupon rate.  So, on the first day of trading, it has a par value of $1,000, and if you held it to maturity (1 year), you would have collected $50 of interest.
• Whenever the bondholder desires, they can convert the bond into 50 shares of Vision’s common shares. The stock price at that time was $20.
• If Vision’s stock price rises to $25, the convertible bondholder could exercise their conversion privilege. They can now receive 50 shares of Vision’s stock.
• 50 shares at $25 are worth $1250. So, if the convertible bondholder bought the bond at issue ($1000), they have now made a profit of $250. If they decide to sell the bond, they could command $1250 for the bond.
• But what if the stock price drops to $15? The conversion comes to $750 ($15 *50). If this happens, you could never exercise your right to convert to common shares. You can then collect the coupon payments and your original principal at maturity.

Capital Structure Arbitrage

This strategy involves purchasing an undervalued security of a firm while simultaneously selling its overvalued security. Its objective is to profit from the pricing inefficiency in the issuing firm’s capital structure.

• Many directional, quantitative, and market-neutral credit hedge funds use this strategy.
• It includes going long in one security in a company’s capital structure while at the same time going short in another security in that same company’s capital structure.
• For example, long the sub-ordinate bonds and short the senior bonds, or long equity and short CDS.

Example

An excellent example of this is when news breaks about a particular company stating that it has been performing particularly poorly. In such a case, its bond and stock prices will likely fall heavily. But the stock price will  fall by a greater degree for several reasons:

• In the case of company liquidation, bondholders have a priority claim, which places stockholders at a higher risk of losing their investment.
• Dividends are likely to be reduced.
• The market for stocks is usually more liquid as it reacts to news more dramatically.
• In contrast, fixed annual payments are made on bonds.

An intelligent fund manager will take advantage of the fact that the stocks will become comparatively cheaper than the bonds.

Fixed-Income Arbitrage

• This Hedge fund strategy profits from arbitrage opportunities in interest-rate securities.
• Traders assume opposing positions in the market to take advantage of minor price inconsistencies and limit interest rate risk. The most common type of fixed-income arbitrage is swap-spread arbitrage.
• Swap-spread arbitrage involves opposing long and short positions in a swap and a Treasury bond.
• The point is that such strategies sometimes provide relatively small returns and can cause huge losses. Hence, this particular Hedge
• Traders often refer to this fund strategy as “picking up nickels in front of a steamroller.”

Event Driven

• Investment managers maintain positions in companies involved in mergers, restructuring, tender offers, shareholder buybacks, debt exchanges, security issuance, or other capital structure adjustments as part of this strategy.
• Also, hedge funds buy companies’ debt in financial distress or have already filed for bankruptcy.
• If the company has not filed for bankruptcy, the manager may sell short equity, betting the shares will fall when it does file.

Global Macro

• This hedge fund strategy aims to profit from significant economic and political changes in various countries by focusing on bets on interest rates, sovereign bonds, and currencies.
• Investment managers analyze the economic variables and their impact on the markets. Based on that, they develop investment strategies.
• The Managers analyze how macroeconomic trends will affect interest rates, currencies, commodities, or equities worldwide and take positions in the asset class that is most sensitive in their views.
• Investors apply various techniques, such as systematic analysis, quantitative and fundamental approaches, and long and short-term holding periods.
• Managers usually prefer highly liquid instruments like futures and currency forwards for implementing this strategy.

Short Only

• The investment strategy of short selling involves selling shares predicted to decrease in value.
• To successfully implement this strategy, the fund managers must scour the financial statements and talk to the suppliers or competitors to dig for any signs of trouble for that particular company.

 The Final Word

We have tried to state various Hedge fund strategies above. I hope people like Jason apply these strategies to make correct decisions and profits for their funds and clients. The first change we may want is a decent office for Jason with colored walls,  admiring clients, and finally, all the spider webs and animals out of his busy office!

Hedge Fund Strategies Infographics

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