Introduction

Hedge funds are investment vehicles that are available only to a selected group of investors, including high net worth individuals who are known as accredited investors as well as institutional investors. Hedge funds are known for their ability to generate high returns, but they are also very volatile and risky investments.

Hedge funds are in a self-regulated industry that are not subjected to the same regulations as traditional mutual funds, allowing them to employ a variety of investment strategies to generate returns. They all share a common goal, which is to generate high returns for their investors. In this article, we will explain five of the most common hedge fund strategies used by fund managers.

Key takeaways

• Hedge funds invest in long and short positions to take advantage of market uptrends and downtrends to generate returns for their investors.
• All strategies are associated with certain risks and may not guarantee returns.
• Market opportunities must exist for some strategies to be employed.

1. Long/short equity strategy

This is one of the most popular hedge fund strategies. Long/short equity funds take both long and short positions in equity and equity derivative securities to mitigate downside risk.

• Long position → buy undervalued stocks that are anticipated to rise in value to profit from the upside
• Short position → sell overvalued and borrowed securities from a brokerage to profit from repurchasing them at a lower price

In general, equity strategies exhibit substantial market risk, which is the risk that the value of an investment will fluctuate over time. This risk is due to the fact that equity prices are often volatile and can fluctuate rapidly in response to changes in the market or the underlying company.

Such a hedge fund strategy can be broadly diversified or narrowly focused on specific sectors. If so, the fund can typically go long and short in two competing companies in the same industry. Not always that managers will hedge their entire long market value with short positions.

In Malaysia, to long or buy shares, the necessary step is to open a trading account and a Central Depository System (CDS) account with a Participating Organisation (PO). (Bursa Malaysia, b) Short selling on the other hand is allowed with an RSS trading account for approved securities on the Bursa Malaysia Berhad Main Market. (Bursa Malaysia, a) Up to 13 June 2022, there are 241 regulated short selling (RSS) approved securities. (Bursa Malaysia, 2022)

Example

Public Bank shares are bought and paired with an equal value to short RHB bank shares. Below are the potential outcomes of price movements:

Long/short equity strategy is not solely based on a single direction of price movement, thus, this fund can take advantage of both the rising and falling of share prices. This strategy can earn an extraordinary return by selecting the correct long and short positions. But then again, if both investments were chosen wrongly, the fund will experience huge losses.

It is more likely that the fund might be right and wrong on certain share price movements. Therefore, a long/short portfolio is formed to limit the downside risk but it also lower potential returns.

2. Event-driven - Merger Arbitrage Strategy

Merger arbitrage strategy seeks to profit from short-term events, involving potential changes in corporate structure, such as an acquisition, that are expected to affect individual companies.

Managers seek to hold equal and offsetting amounts of stock market risk in their long and short positions involved in a merger.

The event-driven strategy typically seeks to produce a return that is not correlated with the broader equity markets. They do this by trying to identify a security that is incorrectly priced in relation to a particular event. In many cases, these events are usually based on individual corporate happenings.

However, if mergers fail or acquisitions are cancelled, this strategy will not be effective and the hedge fund will endure losses. This strategy is also contingent on whether there are opportunities in the market, such as ongoing corporate mergers.

Example

• Event 1: GSC (Acquirer) acquired MBO (Acquired).
• Event 2: F&N (Acquirer) acquired Cocoaland (Acquired).

Action: Short Acquirer and Long Acquired.

If the merger is successful and the market view on both merged companies are positive, both companies’ share price will increase. It results in a higher profit from the long position offsetting the smaller loss from the short position. While it is vice versa for an unsuccessful acquisition.

3. Event-driven distressed securities

This strategy involves investing in companies that are experiencing financial distress and are working through a major event, such as restructuring or bankruptcy. The goal is to profit from the event by buying the securities at a discount and selling them later at a higher price.

Event-driven funds might also use leverage to capture a possibly fleeting opportunity. However, leveraging comes with its own inherent risks which must be managed adeptly, especially if the anticipated outcome does not materialise.

Another risk associated with this strategy is liquidity risk, as the fund's capital could be tied up waiting for the event to occur. If this happens, the opportunity costs also increase over time as the investor's capital is unable to be reallocated to another investment.

Example

If a manager believes that a liquidation is looming or a corporate restructuring, they can take the following actions:

• Purchase fixed-income securities trading at a significant discount to par and short-sell the company’s stock
• Buy senior debt and short junior debt
• Buy preferred stock and short common stock

The manager purchases the target company's debt with the expectation that the recovery value will surpass the initial cost. They may also sell the company's share in the market with the goal of repurchasing it at a lower price when the company bankrupts in future.

The priority to claim during a liquidation serves senior and junior debt holders preferred stockholders and then common stockholders.

To hedge against the outcomes of either recovering or bankruptcy, taking both long and short positions allow the profit from one position to offset the loss from the other. Such as, the gain in short outweighs the loss in long when the company goes bankrupt.

4. Global Macro strategy

The global macro strategy uses a top-down approach where it identifies economic trends evolving across the world. Then, investments are made on the basis of expected movements in economic variables and their impact on the markets.

These funds usually trade opportunistically in the fixed-income, equity, currency and commodity markets. Managers tend to take positions in the asset class that is most sensitive to macroeconomic trends. Short and/or long positions are used to potentially benefit from a view on overall market direction, which is influenced by major economic trends and/or events.

Different techniques like qualitative and fundamental approaches, as well as long and short term holding periods, are employed.

Example

The fund manager sees that India has excellent potential for growth and takes long positions in the country's assets. He also observes that Denmark is going into a recession, so he short sells stocks and futures contracts on major Denmark indices and their currency-the Danish Krone.

5. Relative value strategy - Convertible arbitrage

The convertible arbitrage strategy seeks to profit from a pricing discrepancy (an unusual short-term relationship) between related securities. Convertible arbitrageurs aim to exploit inefficiencies in the market by taking simultaneous long positions on convertible bonds and short positions on common shares.

The expectation is that the value will converge over the investment holding period in which the hedge fund manager will earn a spread or premium, that once existed between the two securities.

Positions with substantially offsetting risks are used in convertible arbitrage strategies to minimise some risks, such as equity market and interest rate risk, but are exposed to other risks, such as credit risks.

Convertible arbitrageurs must be able to accurately predict the future movements of the markets in order to profit from their positions.

Example

The arbitrageur can make a profit with relatively low risk whether the underlying share price rises or falls, instead of speculating in which direction the price will move.

Additionally, the losses suffered from bonds are limited as they are legally protected, and bondholders are entitled to the predetermined payout. They also have priority in claims in the event of liquidation as they are also considered creditors of the firm.

Bottom line

A hedge fund could be a single-strategy or multi-strategy hedge fund. Ultimately, it depends on the fund manager’s expertise in investment strategies and specific sectors to generate returns for investors.

References

• Ashish Kumar Srivastav. Hedge Fund Strategies.
• Bursa Malaysia. (June, 2022)
• Bursa Malaysia, a. FAQS ON REGULATED SHORT SELLING.
• Bursa Malaysia, b. Equities.
• Crystal Capital Partners. (January, 2022). Event-Driven Strategies.
• CAIA. Alternative Investments: CAIA Level 1.
• Hayes, A. (June, 2022). Convertible Bond Arbitrage.
• Hedge Fund Research. HFR Hedge Fund Strategy Definitions - Macro.
• WallStreetPrep. Long-Short Equity.

Author

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This article is written by Joyce Lok Wye Jen, Research Analyst Intern

Joyce Lok Wye Jen is currently majoring in Finance at Tunku Abdul Rahman University of Management and Technology (TAR UMT). Joyce interns at TED Optimus Sdn. Bhd. for 3 months. She participated in Bursa Inter-Varsity Stock Challenge 2022 (BISC). She is also a CFA Level 1 candidate. She is an in-house author from TED Optimus.