Beyond the Basics: A Deep Dive in Hedge Fund Strategies

One of the advantages of hedge fund investing is access to sophisticated investment strategies. Given access to flexible and dynamic investments, there are multiple ways of leveraging your investment to enhance returns and fortify your portfolio.

However, no strategy is suited for every market environment. Some outperform depending on manager skill and market environment.

In this blog, we’ll explore some of the hedge fund strategies, explain how they work and what they are particularly useful for.

Deep Dive in Hedge Fund Strategies

Specific strategies that managers employ for hedge funds vary based on market conditions and each individual manager’s analysis and risk appetite. In general, a manager will try to find a way to secure quality risk-adjusted returns, while still leaving the door open for greater absolute results.

Having said that, here are a few of the specific strategies that experienced hedge funds frequently implement:

Long-Short Equity

Strengths: Large degree of diversification. Flexible. Can profit from both rising and falling markets. Can reduce portfolio risk and enhance returns.

Weaknesses: Requires sophisticated fundamental understanding of a large number of companies. Resulting portfolios may remain sensitive to skew, correlation fluctuations and unexpected market conditions. 

The Long-Short Equity Strategy is a fundamental investment approach that seeks to capitalize on the appreciation of undervalued securities while simultaneously hedging against market risk by short-selling overvalued securities. This strategy involves taking long positions in stocks that are expected to increase in value and short positions in stocks anticipated to decline.

By balancing and actively managing these positions, the strategy aims to generate returns that are less correlated with market movements, thereby providing potential for absolute returns regardless of market direction. 

Distressed Debt

Strengths: High potential returns. Opportunities to benefit from restructuring or liquidation situations.

Weaknesses: High risk. Requires a deep level of understanding of the company's situation

Investing in distressed debt involves purchasing securities of companies in financial distress, such as bankruptcy. These securities are often sold at discounted prices, presenting opportunities for substantial profits if the company successfully restructures or liquidates its assets.

There are two main approaches: passive investing, which involves buying and holding distressed securities (sometimes hedged with market or sector securities) until they appreciate, and active investing, where investors get involved in the restructuring process, possibly influencing the outcome.

Successful distressed debt investing requires a considerable understanding of the distressed firm's background, its assets’ earnings power, and the firm's willingness to restructure and repay its debt. Risks also stem from the long-biased nature of the strategy and the lower liquidity of the distressed securities.

Fixed-Income Arbitrage

Strengths: Absolute returns. Minimal volatility during normal market conditions. Ability to exploit mispricings.

Weaknesses: Relies on market stability and bond security.

Fixed-income arbitrage involves buying and selling a range of fixed-income securities to exploit inefficiencies and price differentials. It relies upon the fact that similar items usually reflect the same value yet are not always sold for the full value.

The strategy carries risks such as the market value risk, where the value of investments might decrease, or credit risk, where the issuer may default on payments. In addition, sometimes it can be hard to sell bonds when you need to, or there might be issues with borrowing the bonds you want to sell. Because of the small pricing discrepancies the strategy requires holding larger books on both the long and short sides, which makes it vulnerable to sudden changes of risk sentiment, market liquidity, or financing conditions.

Manager Selection

Selecting the right hedge fund managers is an essential piece of the puzzle when it comes to performance through hedge fund allocations. The effectiveness of the strategy is only as good as the knowledge, experience, resources at disposal, and processes of the manager. Below are characteristics of quality hedge managers.

Knowledge of markets

Many strategies rely on the fact that managers understand how their markets work and involve intricate knowledge of different financial markets and instruments. Without this knowledge, managers may miss nuances of market pricing and weaknesses within their strategies.

Risk management

Skilled managers are adept at identifying and mitigating potential risks while banking on opportunities that arise with varying market conditions.

Strategic Vision

Quality managers are able to timely position their investments, so as to increase the probability of quality returns for the looming market conditions and risk-return pay-offs. Without forethought or planning, a hedge manager will fail to maximize steady risk-adjusted performance.

Identify Quality Hedge Funds

Finding a hedge fund manager with a quality investment process is essential to getting the most out of a hedge fund investment.

At Resonanz Capital, we have a proven track record of successfully handling complex hedge fund portfolios for institutional investors.

Contact us today and let us help fortify your portfolio for you, and your clients.