Introduction to Hedge Fund Investment Strategies

Hedge funds can be classified into four main categories, with each major type including numerous sub-strategies.

Security Selection

A security selection strategy focuses on investments in the stock market, combining long and short strategies in order to eliminate market risks. Managers employing this strategy are generally unrestricted stock-pickers. This strategy encompasses four sub-strategies:

• Long bias - Emphasis on long positions over short positions, with net long generally in the range of 40% to 60%
• Short bias - Short selling strategies outnumber long strategies, with net short generally in the range of 60% to 80%
• No bias - Long selling and short selling strategies approach a balance, with a risk generally in the range of -20% to +20%
• Variable bias - Opportunistic strategy based on the current view of the market on the strength of long, short, or neutral strategies

Many managers who work within the scope of these strategies maintain their own particular investment focus (for example, U.S. mid-caps, European large-caps, or information technology). As such, the investment portfolio can be structured by selecting outstanding managers to provide diversified regional and industry coverage.
　

Specialist Credit

A specialist credit strategy is based on loans to credit-sensitive issuers (whose credit ratings are generally lower than investment grade). In general, the advantage of this type of investment stems from high-level of due diligence and profits arising from securities that the manager believes are under-priced. The low prices of these securities may be due to irregular rules or other restrictions affecting traditional loans (rules concerning time needed to make policy decisions and on public disclosure). As it is difficult to distinguish providers of this form of credit from private equity investors and other creditors not associated with hedge funds, they can be considered on the periphery of the hedge fund world.

Returns derive from capital appreciation or from taking a position in (or both) the credit-sensitive investment. In addition, the degree of credit sensitivity can provide the manager with an opportunity to negotiate favorable terms. Because this strategy naturally involves the problem of credit risk, thorough due diligence is the key to managing risk effectively.

An investment strategy geared towards distressed securities targets companies facing financial difficulties. Managers employing this strategy seek capital appreciation and do not focus on high-yield features of the assets. A credit trading strategy is based on credit analysis or the outlook for securities and credit markets, seeking credit-sensitive securities to buy long or sell short (or both simultaneously). A private placement strategy generally uses U.S. Regulation D to pursue short-term investment in publicly listed companies. This regulation allows small companies to raise capital relatively inexpensively. The manager's objective is to achieve profits from the embedded stock options in these financing agreements.

Relative Value

Relative value managers focus on the price differentials between financial assets and spot market prices. By using this approach, the risk of outright purchase is eliminated. However, risks associated with price spreads may be quite pronounced. Mathematical and statistical techniques and models are usually employed to check relative value trading opportunities and protect against losses, especially when hedge strategies require frequent trading in hedge instruments in order to maintain market neutrality.

These hedge opportunities generally carry a very low risk but have correspondingly low returns. Therefore, many managers use leveraging to enlarge returns to a more attractive level. These managers' objective is to seek market neutrality, and use various tools to hedge risks based on the particular strategy.

An arbitrage strategy attempts to locate pricing anomalies in related or similar instruments. The area covered by an arbitrage strategy is defined by the type of assets involved-for example, convertible bonds, fixed-income instruments, and mortgage debts. A merger arbitrage strategy uses acquisition activity to earn the price spread between the market value of a security before the acquisition and its value after the acquisition. A statistics arbitrage strategy uses a systematic model to construct a long and short position to obtain all statistically reasonable price spreads. Differing from other arbitrage strategies, a statistics arbitrage manager focuses on the macro nature of a long and short position, rather than on a single position.

Directional Trading

Directional trading is based on predictions of the directions for currency prices, commodities, stocks and bonds in the formal and cash market. The time lags for traditional investments are large, but the key lies in the manager's ability to respond to emerging situations quickly enough to change his outlook on the market. Some traders rely on model-based systems that produce signals to buy or sell. Others use a more subjective approach, in the end relying on their own judgment in choosing trades. The strategies generally used by commodity trading advisors (CTA) belong to this category.

A discretionary trading strategy focuses on opportunistic participation in market price movements. The final decision for trades is made by the manager himself. A systematic trading strategy relies chiefly on technical analysis of market data or computer models-based data on economic fundamentals to check and select trades, with little intervention by the manager. Tactical allocation is employed when an opportunity is sensed to strategically allocate assets in a broader trading strategy and the market.

This type of strategy is the most unpredictable in practice. However, it must be stressed that the linkage of returns on these funds to traditional indices is quite low. This can be partly attributed to the fact that managers using these strategies can produce positive returns in both bull and bear markets. They are quite variable in their view of how the market is moving: All they care about is accurately predicting the direction of the market.