The 17+ Most Popular Hedge Fund Strategies
Hedge fund strategies are generally placed into a few different buckets.
The main overaching categories of hedge fund strategies include:
- global macro
- statistical arbitrage
- event-driven
- directional
- relative value
- distressed investing
Each of these strategies employs a different approach to investing and comes with its own unique risks and reward profile.
There are also numerous sub-strategies and those that don’t cleanly fall into one bucket or another.
Many hedge funds employ multiple strategies and consider themselves multi-strategy.
And many funds have a certain specialty, such as long/short equitiy, distressed debt, and so on. Some will even specialize in a certain sector with a certain asset class (such as healthcare investing).
Hedge funds tend to be of interest for certain entities – e.g., pension funds, endowments, foundations, sovereign wealth funds, accredited investors – for the following benefits they can provide:
- diversification (relative to their other investments)
- flexible approach to the markets (e.g., can be long or short, not just long, like certain types of investment vehicles like mutual funds)
- risk management (e.g., use of derivatives to cap downside risk)
- access to unique returns streams or unique hedging arrangements
Hedge funds typically have a prospectus or offering memorandum, which provides information to potential investors about strategy or strategies, leverage limits, investment types, and other relevant information.
Elements of a hedge fund strategy include (but are not limited to):
- how the hedge fund approaches the market
- what kind of instruments it uses
- the market sector it specializes in (if relevant)
- its investment approach
- diversification in the fund
Asset classes may include:
- equities
- fixed income (bonds, credit, loans, associated derivatives)
- currencies
- commodities
- interest rates
- cryptocurrency
They might use instruments to invest such as:
- equities (public or private equity)
- fixed income
- options
- futures
- swaps
Strategies can be further split up based on whether investments or trading decisions are selected by computers or humans.
- systematic or quantitative (computer-based trading decisions)
- discretionary or qualitative (human-based trading decisions
The diversification within the fund can vary materially.
There are hedge funds that will concentrate their holdings significantly (e.g., up to 50 percent of the fund in only a few stocks or themes) and those that will position broadly among many different markets and many different strategies.
Some funds will also employ different managers who each pursue their own strategy. In effect, each is like its own hedge fund but under the overall umbrella of one firm.
You will also see some hedge funds describe themselves as:
- absolute return
- market-neutral or directional
Market-neutral funds are designed to not have a beta to the market. This helps them be uncorrelated to the markets and help attract clients looking for this type of return stream.
Directional funds might skew long or short a certain asset class (e.g., dedicated equity short sellers) or multiple asset classes (e.g., long equity and long credit).
Some firms might be directional in the sense that they make trading decisions based on trends in the markets (“trend following“), such as momentum strategies.
The most common hedge fund strategies
Let’s take a look at the main popular hedge fund strategies.
What most hedge funds have in common is that they are largely involved in liquid markets.
While some hedge funds do engage in private markets – e.g., private equity, private credit, venture capital, real estate – most funds operate on a mark-to-market basis.
Global macro
Global macro funds focus on the big-picture moves in global economies and markets.
They might invest in stocks, bonds/credit, currencies, commodities, interest rates, cryptocurrencies, real estate, private businesses, and more.
They may also structure these wagers by investing in the underlying asset markets or make use of futures, derivatives, swaps, and other instruments.
The investment decisions are based on macroeconomic analysis of countries, regions, sectors, or themes.
Some global macro funds will be market-neutral and not have a beta to the market while others will have a directional bias to them.
Classically, global macro funds have done best when they anticipate notable changes in markets.
Many investors like global macro for its flexibility. They can be in any asset class at any time and be long or short.
Statistical arbitrage
Statistical arbitrage (or “stat arb”) hedge funds look to exploit pricing inefficiencies between related securities.
They use statistical models and algorithms to identify these opportunities and trade quickly to capitalize on them.
The goal is to make small profits over a large number of trades, which leads to a low volatility and steady returns profile.
This might involve noticing pricing disparities between securities within ETFs and the underlying shares and going long the relatively underpriced securities and short the relatively overpriced securities.
The traded instruments may be stocks, bonds, options, or other securities.
Event-driven
Event-driven hedge funds are so-called because they invest in securities that are reacting to certain events.
These events can be company-specific (e.g., earnings, M&A, spin-offs), industry-specific (e.g., changes in regulation), world events (e.g., natural disasters), or macroeconomic (e.g., interest rates, inflation).
The hedge fund will try to profit from the market’s reaction to the event by trading securities before, during, and after the event occurs.
Directional
Directional hedge funds are ones where the investment decisions are based on directional views of markets.
This could mean being long or short certain asset classes (e.g., stocks, bonds, commodities) or having a view on the direction of a certain market (e.g., US Treasuries, the S&P 500).
They make directional bets by using futures, options, and other derivatives to express their views.
These hedge funds will have a higher volatility than market-neutral or trend-following hedge funds as they are taking active bets in the markets.
Relative value
Relative value (RV) hedge funds look to exploit pricing inefficiencies between related securities.
However, unlike statistical arbitrage hedge funds, which are often high-frequency trading (HFT) firms, relative value hedge funds tend to trade less frequently.
Nonetheless, some consider stat arb a sub-strategy of relative value, as it can have a relative value character to it.
Some of the more common relative value typically entail holding the securities for longer periods of time in order to let the mispricing correct itself.
This might involve noticing discrepancies between two similar securities, such as a bond and its derivatives or between two ETFs that track the same index.
The hedge fund will then buy the undervalued security and sell the overvalued one.
There are also numerous relative value sub-strategies:
Credit long/short
Just like long/short equity, but investing or trading in companies’ credit rather than their equity.
Asset-backed securities (fixed income arbitrage)
Asset-backed securities strategies are usually a type of fixed income arbitrage strategy but using asset-backed securities.
Statistical arbitrage
Stat arb, as we covered, is about pricing inefficiencies between securities or instruments through mathematical or statistical modeling techniques.
Fixed income arbitrage
Fixed income arb is about pricing inefficiencies between fixed income securities that share common characteristics.
Regulatory arbitrage
Regulatory arbitrage is about exploiting differences between two or more markets, geographies, or political areas.
Risk arbitrage
Risk arb exploits market discrepancies between the acquisition price and stock price.
Equity market neutral
Equity market neutral is about being long and short stocks within the same industry, sector, industry, country, size (i.e., market capitalization) and also helps hedge against the broader market.
This strategy aims to not be correlated to the market.
Convertible arbitrage
Convert arb exploits pricing disparities between convertible securities and the corresponding stocks.
Volatility arbitrage
Exploiting changes in volatility instead of changes in price.
This is typically accomplished through derivatives, such as options or swaps.
Yield alternatives
This is a type of arbitrage strategy that’s not related to fixed income that focuses on the yield of an investment rather than the price.
Value investing
Value investing focuses on fundamental analysis.
Proponents of value investing try to buy securities they believe are underpriced/below their fundamental value.
Distressed investing
Distressed investing hedge funds specialize in investing in financially distressed companies.
This can involve buying the debt of a company (usually at a discount to par value), or buying equity in the company when it is trading below its book value.
The hedge fund will then hope to turn the investment around and sell it for a profit, either through restructuring or bankruptcy proceedings.
Some hedge funds also do activism (i.e., pressuring the management of the company to make changes that will improve the financial position of the company).
Mezzanine finance
Mezzanine finance hedge funds provide financing between senior debt and equity.
They usually provide financing in the form of subordinated debt, second lien loans, or preferred stock.
Hedge fund strategies – Summary
Global macro hedge funds are hedge funds that take a global view of the markets.
They make investment decisions based on macroeconomic factors, such as interest rates, inflation, and currency movements.
Their goal is to profit from price movements in the securities they invest in, regardless of the direction the market is moving.
Statistical arbitrage hedge funds are hedge funds that exploit pricing inefficiencies between related securities.
They do this by using mathematical modeling techniques to identify pricing discrepancies.
Risk arbitrage hedge funds are hedge funds that exploit market discrepancies between acquisition price and stock price.
Value investing is a strategy where the hedge fund buys securities that appear underpriced by some form of fundamental analysis.
Event-driven hedge funds trade or invest in securities that are reacting to certain events.
These events can be company-specific, industry-specific, macroeconomic (e.g., interest rates, inflation), or based on general “what’s going on in the world” phenomena.
The hedge fund will try to profit from the market’s reaction to the event by trading securities before, during, and after the event occurs.
Directional hedge funds are ones where the investment decisions are based on directional views of markets.
This could mean being long or short certain asset classes (e.g., stocks, bonds, commodities) or having a view on the direction of a particular market (e.g., US equities, European sovereign bonds).
Relative value hedge funds are hedge funds that exploit pricing inefficiencies between related securities.
They do this by buying the undervalued security and selling the overvalued one.
Distressed investing is a type of relative value hedge fund strategy where the hedge fund invests in securities of companies that are in financial distress.
There are also numerous other sub-strategies within hedge funds, such as convertible arbitrage, credit long/short, statistical arbitrage, volatility arbitrage, yield alternatives, and regulatory arbitrage.