Insights

A Hedge Fund Primer, Part 2

October 21, 2014

In Chapter 1, we discussed how difficult it is to organize hedge funds into neat categories.  Sure, Billy Joel is a rock ‘n’ roll artist to the casual listener, but for one aficionado who has followed his career for decades, he “taps into the deep well of American blues, folks and gospel” and is “chiefly a melodist in the McCartney vein (even though he sees himself as a Lennonite).”1

Let’s keep this discussion of hedge funds casual. If you categorize hedge funds by the types of investment exposure they target, you can capture a number of sub-styles and also gain a bird’s eye view of some of the roles that hedge funds can play in portfolios.  


Directional funds gain or lose when their underlying markets or securities move in one direction or another.

  • Long-Short Equity: These funds invest in equities—long and short—after conducting fundamental and/or technical analysis to determine if companies are incorrectly valued by public markets. Long-short equity funds can focus on specific sectors — such as healthcare or financial services — or take a more general approach.
     
  • Long-Short Credit: As the debt analog to long-short equity funds, credit funds take long positions in any of a number of different credit instruments—from high-yield bonds to senior secured loans. They generally use credit default swaps, either on an index or on a single credit, to achieve short positioning. Decisions are based on credit and sector assessments of the issuers as well as technical factors in markets.
     
  • Short-Biased Funds: These funds are generally managed with a net short orientation, seeking opportunities to benefit from overpricing of specific securities.

Quite differently from directional funds, relative value funds attempt to hedge out directional risk, often by matching long and short positions or using derivatives. Their performance is driven by how securities’ prices move relative to each other.

  • Market Neutral: These strategies minimize exposure to the market and generate returns through their ability to select individual stocks (i.e., minimize beta and maximize alpha). For instance, a market-neutral fund manager might long and short 50% of their fund respectively, achieving a net exposure of 0% and generating returns purely through individual stock movements. Market neutral managers tend to pay attention to the specific securities creating offsetting exposure, often explicitly pairing each long position with a short one that is expected to respond similarly (but worse) to overall market movements. In order to achieve a market neutral portfolio while generating absolute returns, many managers will employ mathematical models and sophisticated algorithms.
     
  • Capital Structure Arbitrage: A company’s capital structure refers to the unique collection of instruments through which its operations are funded. The most common of these instruments are, of course, stocks and bonds. There is a pecking order to the parts of a capital structure, with bonds sitting above stocks in terms of investor protections in the case of bankruptcy. Sometimes the prices of different securities in the capital structure become out of whack. In an extreme example, a bond, which pays income and is safer than equity in the same company, is priced much more cheaply than that equity. This could represent a trading opportunity.
     
  • Convertible Arbitrage: Convertible arbitrage is a specific example of capital structure arbitrage. In this case, the two securities being compared are the common stock and convertible bonds of the same company. For instance, a hedge fund might take a long position on a convertible bond (so-named because it is convertible to common stock at a set conversion price) and a corresponding short position in the common stock if it believes that the equity is relatively overpriced.

Macro funds take positions in economically-sensitive securities, including commodities, currencies and sovereign credits.

  • Quantitative Macro: Analysis and decision-making in quantitative macro funds are driven by algorithms, i.e. mathematical models which identify subtle anomalies affecting price changes.
     
  • Discretionary Macro: In these funds, people conduct the analysis — often with the help of math and technology — but ultimately apply a more subjective approach to the trading decisions.

Event-driven funds express a view on the viability of announced or unannounced corporate transactions. These can include mergers, acquisitions, shareholder buybacks and many others. Event-driven funds either place bets on entire markets or individual securities or a combination of both.

  • Activist: Funds that seek to play an active role in the management of a firm and push for major structural changes come under the domain of activist funds. Activist investors often take large stakes in public companies to effect major changes, with the goal of unlocking more shareholder value. Famous activist investors like Bill Ackman and Carl Icahn are often in the news in the hope of pressuring management to make changes and/or influencing public opinion either for or against a company. The spinoff of PayPal by EBay is a hot-off-the-presses example of a firm targeted successfully by activist investors.
     
  • Distressed: Distressed investing is typically more directional (in the long direction) than other strategies, as it involves investing in near-bankrupt companies that have plummeted in value. Distressed investing can involve both debt and equity positions and is sometimes filed under event-driven because the bankruptcy of a firm is a significant event. 
     
  • Merger Arbitrage: Similar to the “pairs investing” strategy of convertible arbitrageurs, merger arbitrage funds simultaneously buy and sell stocks of two merging companies to exploit pricing inefficiencies before or after these corporate events. The ability to analyze and predict the successful execution of a merger or acquisition is the key aspect of this subcategory of event-driven investing.

Multi-Strategy

A single hedge fund organization may run a number of different strategies. In addition to offering each one individually, the fund shop may also package them into a multi-strategy offering, creating discipline around the amount and timing of allocations to each strategy.


The above list is neither exhaustive nor the only way to classify hedge funds. In addition to all of the subcategories we don’t list here, new ones will probably arise as creative hedge fund managers find new inefficiencies to mine—which is, in the end, their job. Imagine that the list above is about classical music, explaining the differences between symphonies, concertos, suites and operas, or listing all the standard instruments. And then a composer like Leroy Anderson comes in and writes a piece for a typewriter. The piece is still clearly classical music, but in the strictly regulated world of mutual funds, the fund strategy version of that typewriter piece could never be performed. Among hedge funds, however, it could be tried. As could jazz and rock ‘n’ roll, though a composer specializing in classical music would probably be wise to stay within the universe of his expertise. In highly technical fields, intuitive leaps require a very solid foundation to use as a springboard—but a new instrument within one’s field of deep knowledge can lead to great things.

Why invest in hedge funds?

If you’re the kind of person who thinks it’s outrageous that someone would even try to compose a piece of classical music for a typewriter, then hedge funds may not be a great fit. But if you’re curious enough to listen, whether you end up liking it or not, then we suggest you keep reading. Our next module will address the question of why hedge funds are worthy of your consideration.


1The New Yorker, Oct 27, 2014

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