Types of Hedge Funds
Speaking very generally, hedge funds can be categorized as directional funds (so-called macro funds and most long/short funds) and absolute-return-oriented or ARO funds (sometimes called nondirectional funds or market-neutral funds). Hedge funds, however, are not truly nondirectional or market neutral.
Most directional macro funds employ few or no hedging strategies, but simply make bets on their specific ideas, whereas long/short funds are mainly similar to long-only managers except that they also sell stocks short, thus reducing (but not eliminating) their exposure to broad market trends. Many hedge funds fall easily into these broad categories, but some do not.
Hedge funds can also be categorized according to the kinds of investment strategies they follow. Following are some of the many examples of strategies a hedge fund might focus on:
Convertible security arbitrage. Many companies issue convertible securities—securities that are convertible into another company security at a stated price. Depending on the characteristics of the company, the price volatility of the securities, the relative price level of the securities, the level of interest rates, and other factors, the two securities will tend to trade in a price relationship with each other that can be ascertained. If the securities are trading outside this range, the difference can sometimes be arbitraged at a profit.
Distressed debt. Most investors are familiar with high-yield bonds—lower-rated bonds that must offer a much higher yield than traditional bonds. Hedge funds tend to work even lower down in High-Yield Land, buying all or parts of bond issues that have already defaulted and that are mired in bankruptcy proceedings. This sector of the distressed debt market tends to be highly inefficient. Not only must the hedge fund manager accurately estimate the issuer's ability to reorganize and make good on the bonds (or at least pay more for them than the hedge fund paid), but the hedge fund must assess the complex legal rights of the parties to the bankruptcy proceeding and estimate when (if ever!) the company will emerge from bankruptcy. Very often, distressed debt investors find that they must get proactively involved in the bankruptcy proceedings or even in the management of the company in order to realize value.
Event-driven. These are mainly merger arbitrage hedge funds. When a merger is announced there will always be at least some degree of doubt about whether the transaction will actually close. As a result, if the buyer is offering $27 a share, the seller's stock price will remain somewhat below $27 until the transaction actually closes. Arbitrageurs who study the potential acquisition carefully can buy the seller's stock long, sell the buyer's stock short, and make a profit when the transaction closes—a profit that is largely independent of the direction of the market (because the arbitrageur has hedged his position).
Long/short equity. This is the classic hedge fund, buying stocks long that the manager believes will rise in value and selling stocks short that the manager believes will decline in value. As noted elsewhere, this promising-looking strategy is much more difficult to implement successfully than it looks—especially on the short side.
Short-selling. Short sellers are increasingly rare for a good reason: When a long-only or long/short manager performs poorly, he simply underperforms; when a short seller underperforms he goes bust. When we buy a stock long, we limit our risk to the price of the stock—it can only go to zero. But when we sell a stock short our risk is theoretically unlimited.
Global macro. These hedge funds scour the investable universe for compelling opportunities, then make (often staggering) bets on them. The manager might be shorting the kroner or trying to dominate the silver market, and might be leveraging those bets as well. These funds are not for the faint of heart. Global macro managers are especially drawn to currency and interest rate trading. In more recent years, observing the increasingly poor results of the traditional global macro players, managers in this space have opted to take many smaller bets, rather than a few larger ones.
Multistrategy. As the name implies, multistrategy hedge funds move their capital around among strategies depending on where they are finding value and opportunity. If opportunities in event arbitrage (or arb) have dried up, a multi-strategy manager might move capital to distressed debt or convertible arb. Given the level of difficulty involved in outperforming in any single strategy, imagine the difficulties posed by performing well in many different strategies. Multistrategy funds are therefore relatively rare and tend to be very large—large enough to employ specialist managers in several different disciplines.
Practice Tip
A special problem with multistrategy hedge funds (multi-strats) is that, too often, they represent less an investment strategy than a business strategy. Most multi-strats began life as convert arb funds. But convert arb is a seasonal strategy: When it works it works, and when it doesn't it doesn't. And when it doesn't, investors redeem. As a result, many convert arb managers morphed into multi-strats. But do they know anything about investing outside the convert arb space? And has the founding manager spread equity around in a fair way? If the founder runs 50 percent of the book but has 80 percent of the economics, take your client elsewhere.
Hedge funds, especially directional funds, are not, strictly speaking, a separate asset class. Hedge fund managers are buying and selling the same kinds of investment assets as long-only managers—they are just employing different techniques. It is true, to be sure, that the risk-return profile of a well-diversified group of long/short hedge funds will be quite different from that of a well-diversified long-only portfolio, and therefore it is important to evaluate directional hedge exposure independently. But this doesn't make directional hedge a separate asset class: A leveraged exposure to the Nasdaq will have a very different risk-return profile from a long-only exposure to the Nasdaq, but no one would consider it a separate asset class. It is better to think of most hedge funds—the so-called long/short, or directional funds—as alpha strategies that can complement the long-only strategies in our portfolios.
Nondirectional hedge funds—more properly called absolute return-oriented funds, or ARO funds—on the other hand, do tend to exhibit more of the characteristics of a separate asset class, at least when we invest in a diversified portfolio of ARO strategies. These strategies tend to be uncorrelated—or loosely correlated—to the broad markets.
