What are the Hedge Fund Strategies ?

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  1. Nikil Mohan

    Nikil Mohan Member

    Sir, My US client who runs several companies overseas, wants to know what are the strategies adopted by Hedge funds ?

    Thanks in advance for your kind reply
  2. Chandrashekar M

    Chandrashekar M Active Member

    Many hedge fund styles exist; the following classifications of hedge fund styles is a general overview.

    Equitymarket neutral: These funds attempt to identifyovervaluedandundervalued equity securities while neutralizing the portfolio’s exposure tomarket riskby combining long and short positions. Portfolios are typically structured to be market, industry, sector, and dollar neutral, with a portfoliobetaaround zero. This is accomplished by holding long and short equity positions with roughly equal exposure to the related market or sector factors. Because many investors face constraints relative to shorting stocks, situations of overvaluation may be slower to correct than those of undervaluation. Because this style seeks anabsolute return, thebenchmarkis typically therisk-free rate.

    Convertible arbitrage: These strategies attempt to exploit mis-pricings in corporate convertible securities, such asconvertible bonds,warrants, andconvertible preferred stock. Managers in this category buy or sell these securities and then hedge part or all of the associated risks. The simplest example is buying convertible bonds and hedging the equity component of the bonds’ risk by shorting the associated stock. In addition to collecting thecouponon the underlyingconvertible bond, convertiblearbitrage strategies can make money if the expectedvolatilityof theunderlying assetincreases due theembedded option, or if the price of the underlying asset increases rapidly. Depending on the hedge strategy, the strategy will also make money if thecredit quality of theissuerimproves.

    Fixed-income arbitrage: These funds attempt to identify overvalued and undervalued fixed-income securities (bonds) primarily on the basis of expectations of changes in the term structure or the credit quality of various related issues or market sectors. Fixed-income portfolios are generally neutralized against directional market movements because the portfolios combine long and short positions, therefore the portfolio durationis close to zero.

    Distressed securities: Portfolios of distressed securities are invested in both the debt and equity of companies that are in or near bankruptcy. Most investors are not prepared for the legal difficulties and negotiations withcreditorsand other claimants that are common with distressed companies. Traditional investors prefer to transfer those risks to others when a company is in danger of default. Furthermore, many investors are prevented from holding securities that are in default or at risk of default. Because of the relative illiquidity of distressed debt and equity,short salesare difficult, so most funds are long.

    Merger arbitrage: Merger arbitrage, also called “deal arbitrage,” seeks to capturethe price spreadbetween currentmarket pricesof corporate securities and their value upon successful completion of a takeover, merger, spin-off, or similar transaction involving more than one company. In merger arbitrage, the opportunity typically involves buying the stock of a target company after a merger announcement and shorting an appropriate amount of the acquiring company’s stock.

    Hedged equity: Hedged equity strategies attempt to identify overvalued and undervalued equity securities. Portfolios are typically not structured to be market, industry, sector, and dollar neutral, and they may be highly concentrated. For example, the value of short positions may be only a fraction of the value oflong positionsand the portfolio may have anet longexposure to theequity market. Hedged equity is the largest of the various hedge fund strategies in terms of assets under management. It is also known as thelong/short equity strategy.

    Global macro:
    Global macro strategies primarily attempt to take advantage of systematic moves in major financial and non-financial markets through trading incurrencies, futures, and option contracts, although they may also take major positions in traditional equity andbond markets. For the most part, they differ from traditional hedge fund strategies in that they concentrate on major market trends rather than on individual security opportunities. Many globalmacro managersuse derivatives, such asfuturesandoptions, in their strategies.Managed futuresare sometimes classified under global macro as a result.

    Emerging markets: These funds focus on the emerging and less mature markets. Because short sellingis not permitted in most emerging markets and because futures and options may not available, these funds tend to be long.

    Fund of funds: A fund of funds (FOF) is a fund that invests in a number of underlying hedge funds. A typical FOF invests in 10–30 hedge funds, and some FOFs are even more diversified. Although FOF investors can achieve diversification among hedge fund managers and strategies, they have to pay two layers of fees: one to thehedge fund manager, and the other to the manager of the FOF. FOF are typically more accessible to individual investors and are more liquid.

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