Common Hedge Fund Strategies

{Jim Bisenius}

A type of alternative investment, hedge funds are private professionally managed funds that use pooled money. The majority of hedge funds are illiquid, which means they keep their investors’ money locked for lengthier periods, and the latter can withdraw it only during specific time frames. However, hedge funds are subject to much less regulation from the U.S. Securities and Exchange Commission (SEC) than other investments, which allows their managers to use various complex strategies to earn active returns for their investors. These include long-short equity, market neutral, merger arbitrage, and event-driven approaches.

Alfred Winslow Jones, an Australian investor and sociologist often considered “the father of the hedge fund industry,” introduced the long-short strategy in 1949. It follows a simple concept of taking long positions in stocks with expected appreciation and short positions in those with expected depreciation. The aim is to reduce market exposure while simultaneously realizing returns from the increase in the long-positioned stocks and the decline in the shorted ones.

One of the most widespread forms of long-form strategy is the so-called pairs trade, where investors balance the long and short positions by buying the stocks of two competing companies within a specific sector. For example, these can be two leading car manufacturers. If one of them appears relatively cheap to the other, a pairs trader might buy $100,000 worth of the first and short an equal value of the second’s shares. The resulting net market exposure is zero, but if the first company indeed does better than the second, the investor will realize a profit regardless of the market’s overall conditions.

The market-neutral strategy also aims at zero net-market exposure. Unlike the long-short strategy that usually has net long market exposure or the long positions in a specific asset or market exceeding the short ones, it has an equal market value for both the long and short positions. Market-neutral hedge funds managers realize returns based entirely on their stock selection. While this strategy is less risky than its long-biased counterpart, the potential returns are also lower.

Market arbitrage is a higher risk version of market neutral. It generates returns from takeovers. After companies announce share-exchange transactions, hedge fund managers may acquire shares in the target company and short the buying company’s shares at the ratio stipulated in the merger agreement.

The deal must pass certain requirements, such as obtaining regulatory approval and the majority of the votes of the target company’s shareholders, while not worsening the target company’s business or financial status.

The price of the target company’s shares is usually lower than that prescribed in the merger per-share value. Thus, this spread compensates the investors for the risk taken if the transaction fails and for the time value of money (TVM).

Merger arbitrage carries significant risk because mergers often do not proceed as expected. Both companies may impose conditional requirements, or regulatory bodies may eventually prevent the transaction. Therefore, hedge funds using this strategy must be fully aware of all the risk it entails along with the possible rewards.

Finally, event-driven strategies lie between equity and fixed income. They function well in times of economic strength with soaring corporate activity. Hedge-funds that employ an event-driven strategy buy the debt of financially distressed companies or those that have already filed for bankruptcy. Their managers often concentrate on senior debt because it is the most likely to be repaid at its full value or see the lowest discount during a reorganization.

Investors have several options depending on whether the company has already filed for bankruptcy. In the first case, they may fare better with a junior class of debt subject to a lower recovery in the reorganization plan. In the latter case, they may sell short equity with the prospect of a shares’ price decline when the company files for bankruptcy or an agreed equity-for-debt swap averts it.

Event-driven strategies also entail some risk and require a certain amount of patience. The reason is corporate reorganizations do not always occur as planned, and often take months or even years. The always-fluctuating financial-markets can also both positively and negatively impact the process.