Hedge funds are useful assets for investors to implement in their portfolios and manage risk. The deciding factor for the success or failure of a hedge fund lies in the quality of the hedge manager.
A quality manager is constantly ensuring their investments are always on the right side of the market’s odds and pay-off profile. A poor hedge fund manager can lead investments astray, failing to take advantage of the benefits and flexibility a hedge fund structure has to offer.
The difference between these two types of managers lies in the knowledge, experience, execution and risk management of the strategies they employ. With quality active management, your investments can appreciate across varying market environments
Let’s take a look at hedge fund strategies and why they are important.
Why do you need a plan?
Understanding hedge strategies is a key indicator of a hedge fund's identity and risk profile. These are the methods through which hedge funds are able to earn high risk-adjusted returns and protect their investors' capital against market downturns. Each strategy is designed to address specific market conditions and opportunities, which, when executed well, can lead to high-quality returns.
Strategies imply how the fund will achieve its objectives, generates returns, preserves capital, manages volatility, and exploits market inefficiencies. The importance of strategy distinction in hedge fund investing can be underscored by several key points:
Differentiation - Not all hedge funds operate in the same manner. Strategies differ from one another, each seeking to offer unique risk/return profiles that appeal to investors with various goals and risk tolerances.
Risk Management - Different strategies have different ways and capabilities to protect capital. A well-defined strategy guides the fund's approach to risk management, ensuring that risks are understood, monitored, and mitigated as effectively as possible.
Resource Allocation - A good strategy will dictate how the fund allocates its resources, including capital, human expertise, and technology. Misdirecting these elements could cause major inefficiencies, which are detrimental to the success of a hedge fund.
Performance Measurement - The success of a hedge fund is often measured against the objectives of its strategy as well as its peers, not just broad market indices.
Let’s take a look at some of the most common hedge fund strategies today.
The Key Strategies Applied by Hedge Funds
Long and Short Equity
Key Strengths: Flexibility, profit from both rising and falling stock prices.
This strategy takes advantage of a hedge fund’s ability to short-sell. It involves buying (going long) stocks that are expected to increase in value and selling short stocks expected to decrease in price. The fund might go long tech stocks they expect to outperform and short (sell) retail stocks they believe will underperform due to a shift in consumer habits towards online shopping. The fund might also long the expected winners and short the expected losers within a sector.
Equity Market Neutral
Key Strengths: Lower market risk, focus on relative stock returns.
A market-neutral fund might use a statistical arbitrage strategy, which involves selling temporarily inflated stocks that usually correlate with other stocks. For instance, if two automotive stocks historically move together and diverge over the short term, the fund might sell the outperformer and go long on the underperformer, betting on the underperformer to rise back to their historical price ratio. This way, the fund hopes to make a profit, whether the stock market goes up or down, as long as the two stock prices come back to moving in tandem like they used to. A similar, but longer-term approach is also applicable in a discretionary approach, though on a much smaller universe of stocks.
Global Macro
Key Strengths: Flexibility, capitalizes on macroeconomic trends.
This strategy takes positions in global markets, including stocks, bonds, currencies, and commodities based on macroeconomic trends. For example, if a fund anticipates that U.S. interest rates will rise, it might sell short U.S. government bonds (which fall in price as rates rise) and buy the U.S. dollar (which typically strengthens with higher rates). This way, the strategy plays international markets without necessarily making itself vulnerable to local market conditions.
Event-Driven
Key Strengths: Capitalizes on corporate events, may be independent of short-term market direction. Exploits price inefficiencies often ignored by the majority of market participants.
Also known as arbitrage strategies, event-driven strategies focus on corporate events such as mergers, acquisitions, and restructurings. An example would be purchasing the stock of a company being acquired while simultaneously selling the acquiring company's stock, aiming to profit from the spread between the current market price and the acquisition price.
This strategy requires intensive research and vigilance but performs largely independent of volatile markets.
Quantitative
Key Strengths: Data-driven, systematically exploits a broad set of inefficiencies.
A quantitative hedge fund strategy might use algorithmic trading to exploit a broad set of inefficiencies in both singe stock prices and macro markets such as futures and FX. For example, the fund could use a model that identifies stocks that have moved significantly on high volume and trade these stocks based on the expectation that the momentum will continue for a short period. This ensures the hedge fund secures windfalls with the data to back it up.
Emerging Markets
Key Strengths: High growth potential, exploit inefficiencies in less developed markets.
This strategy involves investing in the stocks or bonds of emerging market countries that are experiencing rapid growth. For instance, a fund might purchase equities in a Southeast Asian country (often hedged with instruments from other similar countries) anticipating an economic boom due to recent reforms. This strategy is more risky than others but has potentially a high return potential.
Convertible Arbitrage
Key Strengths: Exploits anomalies between a convertible bond and its underlying stock.
In convertible arbitrage, the fund might buy a company's convertible bonds (which can be converted into a fixed number of shares) and short-sell the corresponding number of shares. The idea is to profit from the bond's yield, increased volatility or price appreciation.
A Balanced Risk-Adjusted Process
Quality hedge funds can enhance investor portfolios with dynamic performance and low correlation to broad based indices.
Resonanz Capital we provides you with the tools and knowledge for high-quality hedge fund investments. Contact us today, to start writing your own investment success story.
