Most hedge funds have well-guarded investment strategies. There are three
broad hedge fund categories based on the types of strategies used:
Arbitrage or Relative Value Strategies
Arbitrage takes advantage of inefficiencies in prices of the same product. A
simple example is a car that sells for $2,000 in one county but sells for
$2,100 in the next county. An arbitrageur buys the $2,000 car and sells it in
the next county for any amount between $2,001 and $2,099.
Hedge funds look for inefficiencies in stock, bond, or money market prices,
buy where it is low, and sell where the price is high. Hedge funds use
sophisticated instruments like options to lock in the selling price without
taking on any risk.
Only a few hedge funds are pure arbitrageurs, but historical studies have
proven that they are a good source of low-risk and moderate returns. Because
price inefficiencies in financial markets tend to be quite small, pure
arbitrage requires large amounts of mostly borrowed money. Arbitrage
opportunities are also rare, and if a strategy is too successful, copycats
enter the market and the advantage disappears.
Most arbitrage opportunities are not risk-free. These “relative value”
strategies capitalize on very small price differences, for example, between a
company’s stock and the bonds it issued. A hedge fund can make, or lose, money
by predicting the upward or downward movements of stock and bond prices.
Event-Driven Strategies
These strategies take advantage of one-time events like the acquisition or
bankruptcy filing by a company. Since these events bring down the company’s
stock price, a hedge fund can short the company’s stock: sell it at the current
(higher) price and buy the stock a few hours, or days, later after the announcement
is made and the stock price has gone down. The same hedge fund can take
opposite positions in the company being acquired or a company that is about to
be reorganized, since these events usually increase the stock price. In the
latter case, the hedge fund buys the stock at the current (lower) price and
sells some days later once the price goes up.
Directional or Tactical Strategies
Most hedge funds use directional strategies, like the macro fund popularized
by George Soros and his Quantum Fund. Macro funds are global funds that invest
based on bets on currencies, interest rates, commodities or foreign economies.
They are for “big picture” investors who do not analyze individual companies
but prefer to bet on decisions of foreign governments. Directional strategy
hedge funds are for sophisticated investors who trust the fund manager to know
the way global events shape the way the financial markets will move in a
country or region.
Though smaller than mutual funds, there are an estimated 8,350 active hedge
funds with investments of $875 billion growing at about 20% per year.