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What is a Hedge Fund?

Hedge funds are investment vehicles that explicitly pursue absolute returns on their underlying investments. But what does “hedge” mean? Are all hedge funds hedged? What are the definitions of the hedge fund investment strategies? Understand these hedge fund fundamentals to help to knock open the door of the hedge fund industry. On this page, we focus on explaining hedge fund basics. Interested in knowing more about hedge fund investment and how Eurekahedge hedge fund databases and services can help the investors or fund managers? Read our FAQ section where we have put together a list of the most frequently asked questions.

What is a "Hedge Fund"?

What does it mean to "hedge"?

Are all hedge funds hedged?

Are all hedge funds highly aggressive?

What types of strategies do hedge funds employ?

How are hedge fund investment strategies defined?

What is a "Hedge Fund"?
Hedge funds are investment vehicles that explicitly pursue absolute returns on their underlying investments. The appellation "Absolute Return Fund" would be more accurate, not least as not all hedge funds maintain an explicit hedge on their portfolio of investments. However the "Hedge Fund" definition has come to incorporate any absolute return fund investing within the financial markets (stocks, bonds, commodities, currencies, derivatives, etc) and/or applying non-traditional portfolio management techniques including, but not restricted to, shorting, leveraging, arbitrage, swaps, etc. Hedge funds can invest in any number of strategies and they are perhaps most readily identifiable by their structure, which is typically a limited partnership (the manager acting as the general partner and investors acting as the limited partners) with performance related fees, high minimum investment requirements and restrictions on types of investor, entry and exit periods.

What does it mean to "hedge"?
Not, in fact, an esoteric gardening term, to "hedge" means to manage risk. Any given money manager may make an allocation/investment that could be described as speculative; if this same manager simultaneously makes an allocation to an allocation/investment specifically designed to balance or counter-act any negative performance from his speculative position then this would be his hedging position. There are many types of perceivable risk - Market, Interest rate, Inflation, Sectoral, Regional, Currency, etc. Hedge fund managers utilise the complete arsenal of financial weapons (holding cash, short selling, buying selling or swapping options, futures, commodity and/or currency futures, etc.) and are expert in concocting hedging positions for most conceivable risks.

Are all hedge funds hedged?
No (and this raises the question of how they can call themselves "hedge" funds as touched on elsewhere), some funds may be long-only in stocks, and may even use leverage- making them explicitly speculative and "un-hedged". The correct questions to ask regarding hedge or absolute return funds revolve around how much perceivable and quantifiable risk underlies its returns. Thankfully, there are lots of clever mathematical formulae and clever mathematical people who will be able to help you with this.

Are all hedge funds highly aggressive?
No again. In fact a true hedge fund is, in theory, less speculative than a long-only "traditional fund". Of course there are some real bat-swinging, aggressive hedge funds, but there are also many others that explicitly and methodically pursue consistency of returns and/or preservation of capital. Of course this is not sensationalist or sexy, so this aspect of hedge fund finance seldom sees the light of day within the media.

What types of strategies do hedge funds employ?
You name it and a hedge fund somewhere is probably doing it (or will be able to)! From buy-and-hold to currency arbitrage to futures and options to distressed debt positions, hedge funds can allocate to any and all (depending on their declared style and strategy). The majority of the hedge fund universe is involved in relatively plain vanilla positions, but sexy finance makes the news so hedge funds collectively are invariably associated with the arcane minority.

How are hedge fund investment strategies defined?

Arbitrage:
Involves the purchase of an asset followed by immediate resale, exploiting pricing inefficiencies in a variety of situations in similar or different markets. It is usually regarded to have low risk, but this may differ depending on the circumstances. The most basic form of arbitrage is triangle arbitrage, where an asset is being sold at two different prices at different markets. Such gaps are often closed off almost instantly. Merger arbitrage takes place following M&A announcements as funds may purchase stocks of the target company and short the stocks of the acquiring company. Capital structure arbitrage involves taking advantage of pricing anomalies among different securities issued by the same or related firm. Includes managers who trade in convertible arbitrage (long volatility), option arbitrage (long or short volatility), share class arbitrage, etc, or a combination of these strategies. For example, a fund might go long on a high yield bond and short the stock of the company. Given the nature of opportunities pursued, returns tend to be market neutral.

Convertible Arbitrage:
Uses the implicit call option embedded in a convertible offer to cover a short position in the stock which it can be converted into. When the call decision needs to be made, if the stock price has taken a huge fall, closing the short position would more than compensate for the loss in the bond position. On the other hand, if the stock’s price has spiked, the rise in the convertible position would more than cover the loss in the short position. During the holding period, returns would include the coupon rate on the bond plus the interest on proceeds from the short sale.

CTA/Managed Futures:
Invests in currencies, commodity futures, government securities, options and forex contracts either directly or through a Commodity Trading Advisor (CTA) who are regulated in the United States by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Distressed Debt:
Invests in the debt of companies that are sick, bankrupt or in the course of a turnaround at deep discounts. Given the nature of these securities, there is selling pressure in the market as many of the institutional investors cannot own below investment grade securities. This results in lower demand, coupled with the negative publicity of a bankruptcy filing, leading to an undervaluation which this strategy is trying to capitalise on.

Directional:
A strategy or trade that involves taking an unhedged view on an investment.

Event Driven:
Exploits opportunities in specific situations, such as restructuring, mergers, public offerings, liquidation, leveraged buyouts or hostile takeovers, and is generally unaffected by the movements in the market or trends. They need not necessarily be limited to any particular investment style or asset class. One example of an event driven arbitrage strategy is merger arbitrage, distressed debt, or more generally speaking, distressed securities.

Fixed Income:
Invests in fixed income securities (long, short or both) and/or fixed income arbitrage (exploiting pricing anomalies in similar fixed income securities) opportunities, usually along with the use of leverage. For this strategy, they may focus on interest rate swaps, forward yield curves or mortgage-backed securities.

Long-Only Absolute Return:
Funds that employ an absolute return strategy but by focusing only on the long side of the markets they invest in. Any of the following investment styles may be used:

  • Bottom-up/Value: A value-based investment approach. Managers are predisposed to and focus on stock selection and conduct in-depth, rigorous fundamental analysis of individual securities. Additional effort is made to find mispricing opportunities (undervalued assets) and growth companies via company visits and scrutiny of accounting practices.

  • Top-down:  Managers base their holding decisions largely on country, region and sector selection, credit creation and other major macro considerations. Portfolios typically consist of a blend of debt and equity. Rigorous tests of businesses are also conducted, in similar fashion to bottom-up, although growth is the manager’s priority.

  • Dual Approach: A mixture of bottom-up and top-down – the best illustration of a combination of securities selection and asset allocation. Emphasis is on stock-picking with a macro overlay.

  • Diversified Debt: The manager aims to capitalise on expectations of credit improvement in one or more distressed, high-yield, sovereign, corporate and bank debts. Profitability depends on credit spread tightening. Convertible bonds (equity) can also be held.

Long Bias:
A strategy which consistently has more long than short positions in a portfolio.

Long/Short Equity:
Attempts to hedge out market risk by investing on the long (buy then sell as prices rise) as well as short (borrow, sell and buy as prices go down, and settle the loan) side of the equity markets. The fund’s net exposure to the markets is reduced if not completely hedged out, owing to the short-selling. Managers shift from stocks of small values to that of large ones, resulting in a tilt in the net long or short position to gain returns. Absolute returns are accentuated by such use of leverage and may also make use of options and futures. Note that this strategy is different from a true equity market neutral strategy. The key difference lies in the fact that the manager is betting that one stock will do better than the other relatively, regardless of the general market movement.

Macro Funds:
A top-down strategy that tracks and profits from global macro-economic directional shifts or changes in government policies. This, in turn, affects foreign currencies/economies, interest rates and commodities. Managers using this strategy are usually involved in all kinds of markets, such as long/short equity, fixed income, foreign exchange futures, bonds, etc. The use of leverage (and derivatives, in particular) accentuates the impact of market movements on fund performance.

Market Neutral:
A strategy where the portfolio has balanced long and short positions, either by sector or stock.

Merger Arbitrage:
A strategy that seeks to benefit from the shared price movements of companies involved in mergers.

Multi-Strategy:
Adds a further layer of diversification to asset allocations (as opposed to merely diversifying across asset classes) by investing in more than one of the strategies described here. To loosely analogise, a multi-strategy fund would be the single-manager fund equivalent of a fund of hedge funds. The volatility for this strategy is considered to be variable.

Relative Value:
A strategy operated by managers who seek to exploit equity market inefficiencies by running perfectly matched equity long and short portfolios within the same country or sector. The portfolio is beta neutral. This is an overarching classification and encompasses all strategies that use pair-trading, leverage in a variety of securities and aim to hedge out market risk. For instance, fixed income arbitrage, capital structure arbitrage and long/short equities are all technically relative value strategies.

Risk Arbitrage:
Similar to merger arbitrage.

As can be clearly seen from above, some strategies are specific to a particular asset class or style and some are broader in scope. As a result, overlaps are inevitable. As a database provider, we feel this is an appropriate categorisation of the myriad of hedge fund strategies out there and we encourage participating funds to slot themselves accordingly. Therefore, funds pursuing arbitrage opportunities with a partial allocation to merger arbitrage would be classified under ‘Arbitrage’, but a fund exclusively allocating to merger arbitrage would be slotted under 'Event Driven'.

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