Hedge fund strategies are different ways that investors use to make money while trying to keep risks low. These strategies often involve leveraging advanced techniques such as short selling, derivatives trading, and leveraging, with the aim of outperforming traditional market indices. From macroeconomic trend analysis to event-driven tactics like merger arbitrage, hedge funds employ a spectrum of methodologies to capitalise on market inefficiencies and generate alpha, making them a cornerstone of modern portfolio management for sophisticated investors. Any hedge fund, like a mutual fund, manages pooled money basically. However, it also differs from a mutual fund since the latter caters largely to retail investors whereas multi strategy hedge funds are more prone to catering to high-risk institutions and HNIs since such funds are more flexible to take risks and subsequently create structures. Moreover, hedge funds also are less regulated than mutual funds.
Different types of hedge fund strategies
Following the global financial crisis in 2008, most hedge funds lost plenty of incremental capital to ETFs and passive strategies. The following are seven hedge fund investment strategies.
- Long/Short Equity or Hybrids
- Credit Risk Strategies
- Vulture Funds & Distressed Debt
- Fixed Income Arbitrage
- Convertible Arbitrage
- Arbitrage on relative value
- Corporate Event Strategies
Long/short equity or hybrids
The Long/short equity strategy is about taking short and long positions simultaneously in equity derivatives or equity. Long short strategies are of three types: technical, quantitative, or fundamental. For instance, hedge funds adopt the long short when expecting that a sector or stock will outperform another sector or stock. Also, a long short strategy is employed when the hedge fund expects a ratio mean reversion, for example a gold/silver ratio. However, unlike a mutual fund, a hedge fund does not permit entry and exit seamlessly, while the minimal barrier is substantially high also. Hence it enables the adoption of complex strategies.
Credit risk strategies
Among the other popular strategies of hedge funds is the credit risk strategy. As its name suggests, the strategy normally entails going by the rating curve. For instance, should a bond that is AA rated be as safe as a bond that is AAA rated, but its yields are 100 basis points more, the scope for employing a credit risk strategy arises, and most hedge funds take maximum advantage of these pricing inefficiencies. The average credit risk hedge fund is active in market downturns usually.
Vulture funds & distressed debt
A subset of credit risk strategies, Vulture Funds & Distressed Debt are not only more specialised but come with several legal nuances. If a company faces a liquidity crisis or fails to fulfil its pending financial obligations, its debt will devalue. By using fundamental analysis, vulture funds identify investments that are undervalued, and also come with a long lock-in period usually.
Fixed income arbitrage
Among the other strategies of hedge funds, is the fixed income arbitrage that exploits price differentials arising from pricing inefficiencies that are market related. An example of this would be when yields on the yield curve’s short end are more than long end yields. Ideally, it needs to be the opposite since a longer tenure implies a higher risk, and these situations lead to fixed income arbitrage. Strategies for fixed income arbitrage include capital structure and yield curve arbitrage.
Convertible arbitrage
There are cases where partially convertible debentures (PCDs) or fully convertible debentures (FCDs) have the option of converting the PCD or FCD into a predetermined volume of shares at a pre-fixed price. However, if the company’s valuation changes, the values of such convertibles may be very high. Convertible arbitrage is that strategy that takes long positions in the convertible securities of a company while also taking up short positions in its stock futures simultaneously. It aims at profiting from inefficiencies in the price of the convertible securities of the company relative to its stock.
Arbitrage on relative value
Generally, a high-risk strategy, arbitrage on relative value is often adopted by India and foreign hedge funds. Also termed pair trading in India, it takes the advantage of price discrepancies that are perceived between investments that are highly correlated or deviations from mean correlations over the long term. Strategies for arbitrage on relative value are highly risky since backfiring is possible both ways with losses magnifying. Thus, in-depth expertise and stringent stop losses are a must.
Strategies driven by corporate events
Such strategies of hedge funds exploit changes in stock prices occurring due to certain corporate actions such as takeovers, mergers, restructuring, reorganisation, spin-offs, asset sales, and dividend declaration. Event-driven strategies need modelling expertise and also use artificial intelligence and simulation extensively.
The multi-strategy method approach
Multi strategy hedge funds use a blend of the abovementioned strategies to offer more flexibility to managers of hedge funds. Such multi-strategy funds usually have lower risk tolerance, while also emphasising heavily on preserving capital.
When you need to know more about strategies of hedge funds, or want to start your investment journey, you may visit the Bajaj Finserv Mutual Fund platform to know more about mutual funds and SIPs. Use its Sip Calculator and Lumpsum Calculator to calculate your financial goals better.
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