One of the reasons hedge funds have received so much attention lately from individual and institutional investors is because of their ability to produce positive returns regardless of the direction of the market. As the greatest bull market ever came to an end, it presented hedge fund managers with the perfect opportunity to prove that their absolute return strategies worked and that hedge funds were worthwhile for even conservative, risk-averse investors to pursue.
The hedge fund manager’s ability to produce consistent, positive returns was in large part overshadowed by the outrageous returns that came seemingly to every investor during the 1990s. The only hedge funds that caught the attention of the general public were ones run by famous, and in some cases, now infamous, managers.
This has changed. As equity markets have deteriorated and the fate of global economies has become uncertain, hedging strategies once lost in the bull market have taken center stage, demonstrating that they can produce consistent, absolute returns regardless of the direction of the general market. To arm advisors with a conceptual understanding of the techniques used by hedge fund managers to create risk-reduced, absolute-return products, we will define the characteristics of the four major hedge strategies.
Many of the funds that fall into the Equity Strategies category do not actually hedge to the same degree as some of the other strategies, and therefore do not offer the same risk/return profiles and low market correlations that other strategies do. These non-hedging equity funds fall under the hedge fund umbrella because they differ from traditional funds in terms of their use of leverage and short positions and because of their structure and unregulated nature.
Long/Short The majority of hedge funds take long positions in strong stocks and short positions in weak stocks. The degree of hedging varies from fund to fund; however, in general the strategy has less overall directional exposure than traditional investments, and therefore often exhibits lower market correlations.
Short-Biased Short-biased strategies generally are 50% to 100% short, and therefore produce the best results in downward-trending markets. The manager’s ability to find weak or financially unstable companies is required for superior performance. Interestingly, the short positions give the fund two primary sources of positive return–profit from a decline in stock price and profit from interest earned on the cash proceeds from the short sale.
Sector-Specific These strategies encompass all funds with an industry, geographical, or other niche-market focus. Like short-biased funds, funds in this strategy often have directional biases. This is especially the case in emerging market funds where hedging with short positions or derivatives is not always possible.
Relative-value, or arbitrage, strategies profit from dislocations and mispricings in securities and markets around the world. Market risk is virtually eliminated by offsetting positions in dislocated securities with positions in related, or highly correlated, securities that are priced correctly. The resulting spread between the dislocation and the expected value produces alpha regardless of the market direction. We’ll outline three forms of this strategy: