Introducing Hedge Fund Strategies and Benefits

Introduction

Hedge funds are alternative investments often used by sophisticated investors that employ a multitude of risk management strategies to potentially generate higher returns while mitigating risk. They are notoriously complex and a wide variety of strategies, styles, investment approaches, sizes, and structures are available. As such, it is important to understand how these strategies work and to evaluate the merits of each one.

Definition of Hedge Funds

A hedge fund is a type of investment vehicle that can be tailored to fit many different business strategies and objectives. Unlike mutual funds, hedge funds are not regulated by the Securities Exchange Commission (SEC) and do not have to register with the SEC. Funds are often formed with the intention of pursuing specific market opportunities and leveraging investment strategies not available to other investors.

Overview of Benefits of Hedge Funds

• Ability to Partner with Highly Experienced Managers: Hedge funds are often run by some of the most experienced and successful investment professionals in the world, with access to diverse, advanced instruments.
• Investment Strategies Differ from Traditional Funds: Hedge funds may be able to benefit in many ways from strategies not used by mutual funds and other forms of investments.
• Performance is not Linked to the Market: Hedge funds are structured to benefit in both rising and falling markets.

Alpha Strategies

Alpha strategies refer to the returns of an investment over and above the returns of the securities it holds, without taking extra risks. These strategies are designed to generate returns that are not associated with the benchmark the investor is tracking. Alpha strategies allow hedge fund managers to have complete control over the investments they are making and the strategies they are using to maximize their returns.

Definition of Alpha Strategies

Alpha strategies are strategies used by hedge fund managers that focus on generating returns that are not associated with traditional benchmarks. These strategies are designed to all investors to increase the return of their investments above the average market index or beta. Alpha strategies are based on the manager's ability to identify undervalued investments and to capitalize on market-based opportunities.

Examples of Alpha Strategies

Alpha strategies can vary widely, but some of the most common strategies include:

• Long/Short Equity - Taking simultaneous long and short positions on stocks that are expected to move in opposite directions
• Arbitrage - Seeking out mispriced assets and profiting from the differences in prices
• Global Macro - Taking active positions in global financial markets to capitalise on perceived macroeconomic trends
• Event Driven - Taking advantage of periodic corporate events, such as mergers and acquisitions and bankruptcy filings, to generate returns

Market Neutral Strategies

Market neutral strategies are a type of investing that seeks to remove the influence of overall market movements on the performance of a fund. This is achieved by going long in some securities while simultaneously short selling other securities in varying amounts. Achieving a market neutral position requires a careful balancing and rebalancing of investments so that both long and short holdings move in opposite directions, but still produce a desirable return.

Definition of Market Neutral Strategies

Market neutral strategies attempt to make money while removing the influence of overall market movements. These strategies involve taking long positions in some securities, while simultaneously short selling other securities in varying amounts. Investors attempt to achieve a “market neutral” portfolio in which, if the overall direction of the market moves up or down, the returns from the long and short positions cancel each other out, allowing the investor to make money without being influenced by the market’s direction.

Example of Market Neutral Strategies

An example of a market neutral strategy would be if an investor buys 100 shares of a company at $50 per share, then sells short another 100 shares of the same company at the same price. If the price of the company goes up by 10% the investor’s long positions will have made 10% and their short positions will have lost 10%, resulting in a net gain of 0%. In this example, the investor’s strategy was to take a “market neutral” approach by balancing their long and short movements in the same company. This allowed the investor to make money regardless of the direction of the market.

• Long position in 100 shares at $50/share
• Short position in 100 shares at $50/share
• If the price of the company goes up by 10%, the investor’s long positions will have made 10% and their short positions will have lost 10%, resulting in a net gain of 0%

Arbitrage Strategies

An arbitrage strategy is a type of investment strategy that seeks to exploit discrepancies in the prices of a given security or asset across different markets. The strategy is one of the many methods used by hedge funds to produce returns for their investor base, with hedge funds typically possessing a strengths in exploiting such arbitrage opportunities in the markets.

Definition of Arbitrage Strategies

An arbitrage opportunity is typically created by a mispricing in assets. Arbitrage traders will exploit these discrepancies by buying and selling assets concurrently to create a risk-free profit. It is defined as the simultaneous purchase and sale of an asset in order to profit from a difference in the price. This may occur between different markets (e.g. stocks and derivatives), or with other assets across different markets.

Example of Arbitrage Strategies

An example of an arbitrage opportunity may include buying and selling the same security on different markets or exchanges. This could potentially include buying a stock on one exchange, and simultaneously selling the same stock on another exchange. If the two transactions take place off different market prices, a risk-freeprofit can be realized.

A less common example of an arbitrage opportunity involves exploiting discrepancies in correlation between different asset classes. An investor could potentially buy two different assets, and if the correlation between the two assets moves in the user’s favor, a riskless profit could be realized. This is a more complex example of an arbitrage opportunity, but can present a lucrative way to generate a return on an investor’s capital.

Merger Strategies

Merger strategies involve the purchase of existing companies and businesses in order to diversify a company’s portfolio and reinvest in a new sector or industry. Mergers also offer possible cost savings, economies of scale and an increase in market share. For hedge funds, merger strategies can be an effective way to generate returns over the short or long-term.

Definition of Merger Strategies

Merger strategies involve a public or private company acquiring another company with the aim of expanding its markets, diversifying its portfolio, or gaining economies of scale. Mergers also help firms secure access to new resources, personnel, and technology, allowing them to grow more quickly. This strategy can also be used to increase market share and gain a competitive advantage.

Example of Merger Strategies

Hedge funds may use merger strategies to invest in target companies for a number of reasons, including the following:

• Gain a larger market share and increased profitability
• Improve the company's competitive position
• Gain access to new markets, customers, products, or technologies
• Achieve cost savings and economies of scale
• Diversify the company's portfolio and reduce risk

Event Driven Strategies

Event driven strategies are an altenate fund investing strategy that capitalizes on short-term events, such as mergers and acquisitions, activist investors, and bankruptcies, allowing investments to be made in special situations. These strategies much be positioned carefully in order to secure returns and maximize profits while minimizing any associated risks.

Definition of Event Driven Strategies

Example of Event Driven Strategies

One example of an event driven strategy is an activist position. In this instance, the fund managers would purchase a significant stake in the company and then attempt to influence management decisions in order to maximize their returns. Another example is a merger arbitrage, where the fund manager will purchase stock of a company when it is acquired, in order to capitalize on potential price discrepancies.

There are also specific event driven strategies that are designed to capitalize on particular market opportunities, such as distressed debt investing or leveraged buyout investing. In the case of distressed debt investing, the fund manager will invest in bonds that are issued by companies that are experiencing financial distress. Leveraged buyout investing involves the fund manager purchasing a controlling stake in a publically listed company in order to acquire a majority stake in the business.

Conclusion

Hedge funds offer investors the opportunity to pursue a variety of strategies and enhance their portfolio with alternative investments. The major strategies used by hedge funds can generally be classified as market neutral, event-driven, credit, macro and relative value arbitrage. In evaluating hedge fund strategies, investors need to consider the benefits associated with each strategy, such as the potential for higher returns, tax advantages and lower overall volatility.

Summary of Major Strategies

The major strategies used by hedge funds can be divided into five categories including market neutral, event-driven, credit, macro and relative value arbitrage. They all have different levels of risk associated with them but offer different potential return opportunities.

• Market Neutral: This strategy seeks to generate a return independent of overall market trends. The return is generated from buying and selling stocks with similar risk and return characteristics in long/short portfolios.
• Event-Driven: This strategy seeks to capitalize on events within the market, such as merger arbitrage, distressed debt or spin-offs. It targets event catalysts, such as private equity buyouts and mergers or spin-offs.
• Credit: This strategy focuses on investing in fixed income instruments such as bonds, loans and other debt securities. It is typically less liquid than equity but offers the potential for higher returns.
• Macro: This strategy seeks to take advantage of global macroeconomic trends by investing in global markets. The manager will typically employ a variety of strategies, including equity, fixed income, commodities and foreign exchange.
• Relative Value Arbitrage: This strategy seeks to identify and exploit pricing anomalies in the marketplace. The manager will typically focus on securities such as convertible bonds, arbitrageurs, derivatives and options.

Benefits of Evaluating Hedge Fund Strategies

Evaluating hedge fund strategies offers investors the chance to pursue market opportunities and diversify their portfolio with alternative investments. While each strategy has its risks, it also can provide the potential for higher returns, tax advantages, and lower overall volatility. One way to further evaluate a hedge fund strategy is to analyze the fund's past performance and risk profile. Additionally, investors should consider the strategy’s expected returns, costs, liquidity and available leverage when making an investment decision.