Hedge funds, as their name suggests, were initially established to offer 'hedging' – a strategy designed to reduce the risk of price movements in an asset. Traditionally, this involved taking an offsetting position in a related security or derivative security based on the asset to be hedged. This definition, however, has significantly expanded in recent years, resulting in a broad array of hedge funds, each employing a unique strategy or focus area.
Today, hedge funds span the investing spectrum, from more traditional funds mimicking the strategy of 'hedging' to those specializing in distinctive investment styles or markets. The type of strategies that hedge funds employs include Directional, Market Neutral, Arbitrage, Global Macro, and Event-Driven strategies, to name just a few.
Directional hedge funds tend to take a view on the direction of the market or specific sectors, while Market Neutral funds aim to profit from both increasing and decreasing price trends in numerous markets, thereby limiting exposure to systematic risk. Arbitrage hedge funds exploit price differentials between related financial instruments, while Global Macro hedge funds make plays on currencies, interest rates, commodities, and other macroeconomic factors.
Event-Driven Hedge Funds take advantage of price movements triggered by corporate events like mergers, acquisitions, and restructuring, or even broader occurrences like natural disasters and political upheavals. Then there are Short-Selling Hedge Funds, which focus exclusively on short positions, particularly in overvalued securities.
Besides these, some hedge funds concentrate on distressed debt, where they buy the debt of companies that have filed for bankruptcy or are likely to do so. These 'vulture funds' aim to profit by purchasing debt at a significant discount and then either negotiating better terms or hoping for a turnaround that increases its value.
In addition to the varied strategies, investors have access to funds of hedge funds, which invest in multiple hedge funds rather than individual securities, offering greater diversification. The rise of Exchange-Traded Funds (ETFs) and mutual funds that mimic hedge fund strategies also allows individual investors to gain exposure to hedge fund strategies without the hefty minimum investment typically required by hedge funds.
Derivatives, including options, swaps, futures, and forward contracts, form an essential part of the hedging toolkit. The relationship between these derivatives and their underlying assets – which can include stocks, bonds, commodities, currencies, indexes, or interest rates – is more or less clearly defined, allowing for effective hedging strategies.
Diversification, which involves spreading investments across various asset classes, sectors, and geographic locations, is another form of hedging. For instance, investing in both cyclical and countercyclical stocks can be an effective hedge against market volatility.
Ultimately, hedge funds are complex investment vehicles that employ a range of strategies and techniques to achieve their investment objectives. Whether it's through taking offsetting positions in derivatives, diversifying across various asset classes, or focusing on specific investment styles, hedge funds offer the potential for attractive risk-adjusted returns, albeit with increased complexity. As with all investments, it is crucial that investors thoroughly understand these risks and the particular strategy employed by a hedge fund before investing.
Summary:
Hedge funds can employ many strategies and focus on virtually any kind of investing style or market. They also have the flexibility to change their strategy as they see fit.
Morningstar and other services will group hedge funds into categories and provide benchmarks based on their average performances. As of 2016, there are over 12,000 hedge funds, and over half of those are required to report to the SEC.
This allows Morningstar and other services to mine the data to arrive at benchmarks for various categories of hedge funds. There are many categories that they use, but the main ones have to do with strategies such as Directional, Market Neutral, Arbitrage, Global Macro, and Event-Driven strategies.
Some look for distressed debt, or are short-only, For example, Event-Driven Hedge Funds employ a strategy focused on companies that are involved in special situations such as restructuring, merger and acquisition, natural disasters, political upheavals, etc.
Another example is Short-Selling Hedge Funds - they use a strategy in which managers will take only short positions in overvalued securities. Macro strategies use a top-down approach to global markets and make plays on currencies, interest rates, commodities, and other macroeconomic factors.
There are also funds of hedge funds that give investors a great diversification within this arena. Today, you can also invest in ETFs and mutual funds that mimic and track hedge fund strategies.