Hedge Fund Strategies

There are different types of strategies for investing in hedge funds such as long/short equity, fixed income arbitrage, convertible arbitrage and many more.

Hedge Fund Strategies
3 min

Hedge fund strategies are different ways that investors use to make money while trying to keep risks low. These strategies often involve leveraging advanced techniques such as short selling, derivatives trading, and leveraging, with the aim of outperforming traditional market indices. From macroeconomic trend analysis to event-driven tactics like merger arbitrage, hedge funds employ a spectrum of methodologies to capitalise on market inefficiencies and generate alpha, making them a cornerstone of modern portfolio management for sophisticated investors. Any hedge fund, like a mutual fund, manages pooled money basically. However, it also differs from a mutual fund since the latter caters largely to retail investors whereas multi strategy hedge funds are more prone to catering to high-risk institutions and HNIs since such funds are more flexible to take risks and subsequently create structures. Moreover, hedge funds also are less regulated than mutual funds.

Different types of hedge fund strategies

Following the global financial crisis in 2008, most hedge funds lost plenty of incremental capital to ETFs and passive strategies. The following are seven hedge fund investment strategies.

  1. Long/Short Equity or Hybrids
  2. Credit Risk Strategies
  3. Vulture Funds & Distressed Debt
  4. Fixed Income Arbitrage
  5. Convertible Arbitrage
  6. Arbitrage on relative value
  7. Corporate Event Strategies

Long/short equity or hybrids

The Long/short equity strategy is about taking short and long positions simultaneously in equity derivatives or equity. Long short strategies are of three types: technical, quantitative, or fundamental. For instance, hedge funds adopt the long short when expecting that a sector or stock will outperform another sector or stock. Also, a long short strategy is employed when the hedge fund expects a ratio mean reversion, for example a gold/silver ratio. However, unlike a mutual fund, a hedge fund does not permit entry and exit seamlessly, while the minimal barrier is substantially high also. Hence it enables the adoption of complex strategies.

Credit risk strategies

Among the other popular strategies of hedge funds is the credit risk strategy. As its name suggests, the strategy normally entails going by the rating curve. For instance, should a bond that is AA rated be as safe as a bond that is AAA rated, but its yields are 100 basis points more, the scope for employing a credit risk strategy arises, and most hedge funds take maximum advantage of these pricing inefficiencies. The average credit risk hedge fund is active in market downturns usually.

Vulture funds & distressed debt

A subset of credit risk strategies, Vulture Funds & Distressed Debt are not only more specialised but come with several legal nuances. If a company faces a liquidity crisis or fails to fulfil its pending financial obligations, its debt will devalue. By using fundamental analysis, vulture funds identify investments that are undervalued, and also come with a long lock-in period usually.

Fixed income arbitrage

Among the other strategies of hedge funds, is the fixed income arbitrage that exploits price differentials arising from pricing inefficiencies that are market related. An example of this would be when yields on the yield curve’s short end are more than long end yields. Ideally, it needs to be the opposite since a longer tenure implies a higher risk, and these situations lead to fixed income arbitrage. Strategies for fixed income arbitrage include capital structure and yield curve arbitrage.

Convertible arbitrage

There are cases where partially convertible debentures (PCDs) or fully convertible debentures (FCDs) have the option of converting the PCD or FCD into a predetermined volume of shares at a pre-fixed price. However, if the company’s valuation changes, the values of such convertibles may be very high. Convertible arbitrage is that strategy that takes long positions in the convertible securities of a company while also taking up short positions in its stock futures simultaneously. It aims at profiting from inefficiencies in the price of the convertible securities of the company relative to its stock.

Arbitrage on relative value

Generally, a high-risk strategy, arbitrage on relative value is often adopted by India and foreign hedge funds. Also termed pair trading in India, it takes the advantage of price discrepancies that are perceived between investments that are highly correlated or deviations from mean correlations over the long term. Strategies for arbitrage on relative value are highly risky since backfiring is possible both ways with losses magnifying. Thus, in-depth expertise and stringent stop losses are a must.

Strategies driven by corporate events

Such strategies of hedge funds exploit changes in stock prices occurring due to certain corporate actions such as takeovers, mergers, restructuring, reorganisation, spin-offs, asset sales, and dividend declaration. Event-driven strategies need modelling expertise and also use artificial intelligence and simulation extensively.

The multi-strategy method approach

Multi strategy hedge funds use a blend of the abovementioned strategies to offer more flexibility to managers of hedge funds. Such multi-strategy funds usually have lower risk tolerance, while also emphasising heavily on preserving capital.

When you need to know more about strategies of hedge funds, or want to start your investment journey, you may visit the Bajaj Finserv Mutual Fund platform to know more about mutual funds and SIPs. Use its Sip Calculator and Lumpsum Calculator to calculate your financial goals better.

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Frequently asked questions

What is multi-strategy hedge fund?
A hedge fund simultaneously employing multiple investment strategies is called a multi-strategy hedge fund. It does not focus on a single investment approach like global macro or long-short equity. Rather, it invests capital in multiple geographic regions and asset classes for generating returns from several market conditions and diversified risks.
How many hedge fund strategies are there?
There are no fixed numbers when it comes to strategies for hedge funds, since they vary on their categorisation and definition. There are multiple strategies that hedge funds employ by blending primary strategies or even adopt unique approaches, depending on changing market conditions as also evolving investor preferences.
What is a hedge fund strategy?

A specific methodology or approach that any manager of a hedge fund uses in making investment decisions to generate returns for its investors is called a hedge fund strategy. Each strategy is employed for exploiting specific inefficiencies or market opportunities, while managing the risks involved.

What are the best hedging strategies?

The most effective hedging strategies are formulated on several factors that include prevailing market conditions, all specific risks that need to be hedged, and the fund manager or investor’s goals. The most well-known hedging strategies for mitigating risk are: Futures Hedging, Options Hedging, Diversification, Short Selling, Allocation of Tactical Assets, Pair Trading, and Options Spreads.

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The information contained in this article is for general informational purposes only and does not constitute any financial advice. The content herein has been prepared by BFL on the basis of publicly available information, internal sources and other third-party sources believed to be reliable. However, BFL cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. 

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