Exploring Hedge Fund Strategies | CFA Level I Alternative Investments

Let’s dive into the fascinating world of hedge funds and explore their strategies! In this lesson, we’ll discuss some common characteristics of hedge funds and learn about the different strategies that hedge fund managers employ.

Common Hedge Fund Characteristics

Despite the wide variety of hedge funds, they typically share the following characteristics:

• Aggressively managed portfolios that leverage long and short positions and often use derivatives.
• Higher risks in pursuit of high returns due to less regulation compared to traditional investments.
• Partnership structure with investors as limited partners and the management firm as the general partner.
• Less liquidity than traditional investments due to lockup periods and redemption restrictions.

A fund of hedge funds is an investment company that invests in various hedge funds, providing investors with diversification among hedge fund strategies and access to hedge funds that may not be open to individual investors.

Hedge Fund Strategy Classifications

According to Hedge Fund Research, there are four main classifications of hedge fund strategies:

1. Event-driven strategies
2. Relative value strategies
3. Macro strategies
4. Equity hedge strategies

1. Event-driven Strategies

Event-driven strategies seek to profit from short-term events like corporate restructuring or acquisitions. Examples of event-driven strategies include:

• Merger arbitrage – Profiting from deal spreads between acquiring and target firms.
• Distressed-restructuring – Investing in companies in financial distress or close to bankruptcy.
• Activist shareholder – Influencing a company’s policies to increase its value.
• Special situations – Investing in firms undergoing restructuring activities.

2. Relative Value Strategies

Relative value strategies involve exploiting pricing discrepancies between related securities. Examples include:

• Fixed income convertible arbitrage – Exploiting pricing discrepancies between convertible bonds and the issuing company’s common stock.
• Fixed income asset-backed – Exploiting pricing discrepancies among mortgage-backed or asset-backed securities.
• Fixed income general – Exploiting pricing discrepancies between various fixed income securities.
• Volatility – Exploiting pricing discrepancies arising from differences in returns volatility.
• Multi-strategy – Exploiting pricing discrepancies across asset classes and markets.

3. Macro Strategies

Macro strategies are based on global economic trends and events. Managers take long or short positions in equities, fixed income, currencies, or commodities based on their views on overall market direction.

4. Equity Hedge Strategies

Equity hedge strategies employ a “bottom-up” approach, focusing on individual securities. Examples include:

• Market neutral – Profiting from relative price movements of undervalued and overvalued equities with minimal exposure to market risk.
• Fundamental long/short – Using technical analysis to long undervalued securities and short overvalued securities without equalizing long and short positions.
• Fundamental growth – Using fundamental analysis to identify and buy high-growth companies.
• Fundamental value – Using fundamental analysis to invest in undervalued companies.
• Short bias – Predominantly shorting overvalued equities with potential for smaller long positions and overall negative market exposure.

Most hedge funds tend to specialize in a specific strategy at first. Over time, some may develop or add additional areas of expertise, becoming multi-strategy funds.

Now that you have a better understanding of the various hedge fund strategies, you’re ready to tackle other characteristics of hedge funds in the next lesson.