Difference in hedge fund strategies: A guide through the maze of risk and returns

As family offices, high net worth and institutional investors venture into alternative investments, they face the challenge of comparing different hedge fund strategies to achieve target returns with appropriate risk levels.

These strategies, including macro funds, long/short funds, absolute return funds, and event-driven funds, have distinct approaches to generating gains, leveraging assets, and managing risks. Understanding the mechanics of each strategy is crucial for making informed decisions. Hedge funds help diversify portfolios and provide more stable returns in volatile markets.

What is a hedge fund?

A hedge fund is a pooled investment fund actively managed by professionals through complex trading and risk management techniques to achieve above-average returns. There are three key features:

1. Flexible investment mandates
2. Focus on absolute returns
3. Diverse strategies and risk profiles

Flexible investment mandates

Unlike mutual funds, hedge funds have the liberty to use leverage and short-selling, and are able to invest in non-traditional assets. They have flexible, unconstrained investment mandates allowing them to opportunistically seek profits across different markets.

Focus on absolute returns

Hedge funds aim to generate positive absolute returns regardless of overall market conditions. Their compensation is tied to performance, not simply beating a benchmark. Hedge fund managers may use hedging techniques such as short selling, arbitrage, and derivatives to reduce volatility and preserve capital.

Diverse strategies and risk profiles

There are many hedge fund strategies, each with its own risk profile. Some common approaches include global macro, event-driven, relative value, and long/short equity. Global macro funds bet on global economic trends while event-driven funds profit from corporate activities like mergers. Long/short equity funds combine long and short positions in stocks.

Common hedge fund strategies

Equity Strategies

Long/short equity

Long/short equity strategies aim to generate alpha through skilled stock selection across diverse global opportunities. Fund managers take long positions in undervalued equities and short positions in overvalued equities, aiming to balance risk and return. This strategy can shift across sectors, factors, and regions but typically maintains philosophical biases. 

Market timing plays a secondary role in stock selection, with leverage often used by quantitative managers. Long/short equity strategies are prevalent, accounting for about 30% of hedge funds.

One example of a long/short trade is buying shares of Microsoft Corporation (MSFT) to capitalise on AI and the technology sector’s structural growth trend and short selling shares of GameStop Corp. (GME) to profit from potential share price decline when the market corrects.

Short-biased

In contrast, short-biased funds focus primarily on strategic short-selling of companies expected to lose value. They tend to maintain a net short exposure, profiting when shorted stocks experience price drops. However, short-biased funds face potentially unlimited risk from incorrect short bets.

Equity market neutral

Equity market-neutral strategies balance long and short positions to maintain zero net market exposure, focusing on pairs of securities with mean reversion potential. These strategies offer low standard deviation and high leverage, suitable for non-trending or declining markets.

Event-driven strategies

Event-driven strategies seek to profit from temporary stock mispricings caused by major corporate events like mergers, acquisitions, bankruptcies or restructurings. Specialist teams analyse potential corporate actions and their impacts in depth to identify mispriced securities. According to the CFA Institute, these opportunistic strategies often employ moderate to high leverage.

Merger arbitrage

A prime example is merger arbitrage, a relatively liquid approach centred around mergers and acquisitions. Investors take positions in the target company's stock, aiming to capture the spread between its current trading price and the announced acquisition price. This type of strategy can have high Sharpe ratios but left-tail risk from deal failures, using moderate to high leverage and diverse securities.

Example:

Here is an example trade for this type of fund: If Microsoft is acquiring Activision Blizzard in a cash merger for $95, the hedge fund manager would buy shares of Activision at the current market price of $80. If the merger is successful, the manager would make a profit of $15 per share and of course, the risk here is that there is a risk that the merger may not go through due to regulatory issues, financing problems, or other unforeseen circumstances. 

Continuous monitoring of news related to the merger is crucial and will be part of the risk monitoring and management for the fund.

Distressed investing

Another major event-driven approach revolves around distressed securities - bonds or stocks of companies facing bankruptcy or financial distress. These strategies may profit from the liquidation of company assets or a reorganisation where the firm renegotiates its capital structure.

While steady, merger arbitrage carries left-tail risks. Distressed investing offers higher potential returns but also greater illiquidity and cyclicality according to the CFA Institute. Overall, event-driven strategies capitalise on mispriced situations - but strong analytical skills and the superior ability needed to identify these securities can make it challenging.

Relative value strategies

Relative value strategies seek to capitalise on temporary mispricing between related financial instruments or assets. These fund managers analyse securities relative to each other rather than individually. They aim to profit from price convergence by going long on the undervalued asset while shorting the overvalued one.

Fixed income arbitrage

Debt arbitrage strategies like swap spread arbitrage and yield curve arbitrage take advantage of mispricing across similar debt securities. These strategies typically utilise a large amount of leverage and can have a moderate level of volatility. Analysing this type of strategy requires looking at the correlations, yield spread pick-up and debt security diversity.

Convertible bond arbitrage

One common approach is convertible bond arbitrage, which involves taking a long position in a convertible bond while shorting the underlying stock. These strategies aim to exploit pricing inefficiencies between the bond and equity components. The strategy requires high leverage, performs best during high issuance and moderate volatility, and may have a moderate level of risk. 

Example: 

For example, the hedge fund manager for this type of fund can buy Tesla 2024 Convertible bonds at $1,100 and then short-sell Tesla stock (currently priced at $800) to hedge against the equity risk. This will allow the fund to profit from the yield of the convertible bond and the potential mispricing between the bond and the stock. 

If Tesla’s stock price rises significantly, convert the bonds into shares and sell them at the new market price of $900. If the stock price falls, the fund will profit from the short position and still receive the bond’s yield.

Opportunistic Strategies

Managed futures and global macro strategies are highly liquid investment strategies. However, managed futures funds may experience crowding and execution slippage due to the rapid growth of assets under management. This can make trading costs higher compared to global macro strategies which have less significant execution crowding effects due to their diverse approaches. 

Both managed futures and global macro funds can provide diversification benefits to investors by performing well during periods of market stress. In general, managed futures and global macro funds tend to exhibit higher volatility compared to other types of hedge funds.

Global macro strategies

Global macro strategies focus on worldwide macroeconomic trends and events across equity, fixed income, currency and commodity markets. Fund managers employ a discretionary investment approach, taking leveraged long or short positions based on their views of how political, economic and market factors will impact different asset classes globally. This opportunistic strategy allows funds to profit from global events and shifting market dynamics, depending on how skilled the fund manager is in navigating macroeconomic shifts.

Example: 

A global macro hedge fund manager believes that there will be a strong economic recovery in the US due to aggressive fiscal stimulus and robust consumer spending while the emerging markets remain weak because of uncertainties.

To capitalize on her belief in a strong economic recovery in the US and weak emerging markets, the global macro hedge fund manager may implement the following strategy:

1. Buy shares of the S&P 500 index
2. Short sell shares of the MSCI Emerging Markets ETF

The overall expectation of this strategy is to benefit from the relative outperformance of US equities compared to emerging market equities, based on the manager's belief in the economic recovery in the US and the challenges faced by emerging markets.

Systematic approaches

Managed futures strategies are a type of opportunistic approach focused on implementing systematic trading models across futures, options and derivative instruments linked to global markets. Unlike discretionary global macro funds, managed futures employ quantitative techniques and trend-following models to identify profitable opportunities and dynamically adjust exposures. 

As noted by the CFA Institute, these liquid strategies typically exhibit positive skewness and can provide valuable diversification during periods of market stress.

Niche strategies

Quantitative long/short crypto

The quantitative long/short crypto strategy is popular among hedge funds. It involves using algorithmic models and data analysis to take long and short positions in different crypto assets. The aim is to generate positive returns in both rising and falling markets by going long on outperformers and shorting underperformers. This strategy helps mitigate the volatility risks of crypto markets.

Discretionary long-only crypto

The discretionary long-only crypto strategy is gaining popularity among hedge funds. About one in five crypto hedge funds utilized this approach in 2023. 

Fund managers rely on fundamental research and macro analysis to identify promising crypto assets for long positions. While lacking the volatility dampening of market-neutral portfolios, discretionary long-only strategies can capitalize on the upside potential of disruptive blockchain projects and tokens.

Volatility trading

Volatility trading has evolved into a specialised asset class, with hedge fund managers capitalising on volatility pricing disparities across regions and asset classes. 

Strategies like relative value volatility arbitrage involve buying low-priced volatility and selling high-priced volatility using options, VIX futures, and volatility swaps. 

Key approaches include time-zone arbitrage and cross-asset volatility trading. Instruments used range from exchange-traded options to customisable OTC options and swaps, each with varying liquidity and risks. Volatility trading offers hedging benefits and potential returns due to positive convexity but entails challenges such as counterparty risk, liquidity risk, and premium costs. Despite these challenges, it provides sophisticated strategies that leverage volatility pricing differences.

Reinsurance

Hedge funds engage in insurance-related investments by purchasing insurance contracts and utilising their expertise in analysis and risk management. They may buy life insurance policies from third-party brokers, aiming to receive death benefits that exceed the costs. 

Hedge funds also invest in catastrophe reinsurance, diversifying policies geographically and using models to manage risks. Additionally, they utilise catastrophe bonds and risk futures to take positions or hedge risks in their insurance portfolios, benefiting from their liquidity and uncorrelated returns.

Multi-manager strategies

Investors often combine multiple hedge fund strategies into a single portfolio using two main approaches: Fund-of-Funds (FoF) and Multi-Strategy Funds. These approaches differ significantly in how they operate and manage risk.

Fund-of-funds (FoF)

A Fund-of-funds manager aggregates investor capital and allocates it across various hedge funds, each employing different strategies. 

This approach offers diversification, professional management, and access to hedge funds that may be closed to new investors. FoF managers conduct due diligence, make strategic and tactical allocation decisions, and provide consolidated reporting.

However, investors face a double layer of fees (both from the FoF manager and the individual hedge funds). Minimum investments for individual hedge funds are typically high, but FoFs allow smaller investors to participate with a lower entry point, often around $100,000. Despite the extra fees, FoFs offer convenience, diversification, and potential access to otherwise unavailable managers.

Multi-strategy funds

Multi-strategy funds combine multiple hedge fund strategies under one fund, managed by different teams within the same organization. 

This structure allows for quicker capital reallocation between strategies, better transparency, and more efficient risk management. Multi-strategy funds often outperform FoFs but can experience more volatility and occasional large losses due to higher leverage. 

The fees in multi-strategy funds are generally more investor-friendly because the fund absorbs the netting risk (the risk of paying performance fees to win strategies while others underperform), unlike in FoFs where investors bear this risk. However, multi-strategy funds may have operational risks concentrated within the same organisation and may be limited by the available in-house expertise.

Access top hedge funds on Endowus

Consider your risk appetite, return objectives, liquidity needs, and portfolio construction. The diverse strategies allow you to target outcomes like reduced volatility, positive returns in any market environment, or higher potential gains.

At Endowus, we are working to overcome these hurdles as we provide access to high-quality alternative investments for accredited investors and family offices in Singapore.

With Endowus Private Wealth, clients looking to invest a minimum of US$1 million in assets across our services can gain exclusive access to top-tier hedge fund investments, more personalised investment plans, solutions and products.

Discover a better way to manage your wealth by contacting Endowus Private Wealth for a personalised consultation, or contact our private wealth arm via privatewealth@endowus.com to learn more.

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