Hedge fund is an investment vehicle that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk.
Hedge funds aim to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions.
Hedge funds are only available to a specific group of sophisticated investors with high net worth. The U.S. government deems them as “accredited investors”, and the criteria for becoming one are lengthy and restrictive. This isn’t the case for mutual funds, which are very easy to purchase with minimal amounts of money.
Hedge fund strategies vary enormously — many hedge against downturns in the markets — especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.
There are about 14 distinct investment strategies used by hedge funds, each offering different degrees of risk and return.
Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets. Many hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).
Hedge funds vary enormously in terms of investment returns, volatility and risk. There are hedge fund strategies tend to hedge against downturns in the markets being traded. hedge funds have the ability to deliver non-market correlated returns.
Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
Most hedge funds are managed by experienced investment professionals who are generally disciplined and diligent.
Pension funds, endowments, insurance companies, private banks and high net worth individuals and families invest in hedge funds to minimize overall portfolio volatility and enhance returns.
Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.
Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.
Hedge fund strategies
Fixed income arbitrage: exploit pricing inefficiencies between related fixed income securities.
Equity market neutral: exploits differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, which also creates a hedge against broader market factors.
Convertible arbitrage: exploit pricing inefficiencies between convertible securities and the corresponding stocks.
Asset-backed securities (Fixed-Income asset-backed): fixed income arbitrage strategy using asset-backed securities.
Credit long / short: the same as long / short equity but in credit markets instead of equity markets.
Statistical arbitrage: identifying pricing inefficiencies between securities through mathematical modeling techniques
Volatility arbitrage: exploit the change in implied volatility instead of the change in price.
Yield alternatives: non-fixed income arbitrage strategies based on the yield instead of the price.
Regulatory arbitrage: the practice of taking advantage of regulatory differences between two or more markets.
Risk arbitrage: exploiting market discrepancies between acquisition price and stock price
Fund of hedge funds (Multi-manager): a hedge fund with a diversified portfolio of numerous underlying single-manager hedge funds.
Multi-strat: a hedge fund using a combination of different strategies to reduce market risk.
Multi-manager: a hedge fund wherein the investment is spread along separate sub-managers investing in their own strategy.
130-30 funds: equity funds with 130% long and 30% short positions, leaving a net long position of 100%.
Risk parity: equalizing risk by allocating funds to a wide range of categories while maximizing gains through financial leveraging.