Wondering which hedge fund strategies you should pay attention to? Hedge funds play a major role in the investment world, as they have billions of dollars in assets under management that they invest in many companies, supporting their growth in exchange for returns they achieve from investments. Currently there are over 8,000 hedge funds in existence, with hundreds being launched every year. However, it is hard for a hedge fund to stay afloat, because, since the investments are most often based on speculation, a hedge fund requires a detailed analysis of investment instruments.
Hedge funds have some particularities that make them different from other money managing firms. An investor who wants to get involved in a hedge fund, must have net assets of at least $1 million, and a certain amount of annual net income. Due to this strict eligibility for investors, hedge funds are–for the most part–not regulated in the U.S., which offers them some flexibility and freedom. To learn some more details about hedge funds, see us answer the question “what is a hedge fund“?
While the number of hedge funds with AUM totals in excess of $1 billion total somewhere around only the 500 mark, hedge fund managers are usually wealthy people, with many (but not all) millionaires, which makes this field inherently attractive for piggyback investors searching for strategies.
Generally speaking, hedge funds have many aspects which ensure their proper functioning. However, there is another thing, which is the most important for a hedge fund activity: their strategy. It is applied for finding opportunities that yield high returns with as little risk as possible. Hedge managers often claim that they have developed their own strategy, which stands behind their success.
Even though each hedge fund has something particular in its strategy, which has been introduced and developed by its managers, there are some basic strategies, that are used by all hedge funds. We have compiled a list of several hedge fund strategies that show how money managers can bring in the big bucks.
Let’s take a look on the following pages:
Global Macroeconomic Analysis
Some hedge funds use the overall macroeconomic situation in the world and take advantage of changes that occur in it. Hedge funds choose to invest in different securities like bonds, stocks, or even currencies, focusing not only on one market, but rather globally diversifying their portfolios.
In this way, hedge funds profit from a larger diversity, and can diminish risks that can occur from a downfall in a particular market.
Ray Dalio of Bridgewater Associates (pictured left), manages the world’s largest hedge fund with an estimated $122 billion in assets under management. Dalio is a self-proclaimed macro investor, and is infamous for using a team of analysts to compile constant, real-world macroeconomic analysis.
Another example of focusing on a larger perspective is investing in emerging markets. Emerging markets have a common feature of higher growth than other markets, which means that investing in them brings higher returns, albeit with higher risk sometimes.
While George Soros (pictured left) doesn’t always bet with the tide of EM equities, he’s almost always certain to be in them one way or another (on the short side, too), in addition to the corner stone of his strategy: currencies.
It is often said that forex investing is one of–if not the–hardest investment tactics, due to the 24/7 nature of the global marketplace, in addition to the complexities that arise in forecasting currency behavior. Well, a close second–at least in terms of difficulty–to currencies would have to be emerging market equities, as public information about these companies is less available than the typical NYSE or NASDAQ-listed stock.
Still, for those willing to dig down, EM investing is an important piece of anyone’s strategy. In addition to Soros, we’d watch Brian Kelly’s Asian Century Quest.
Hedge fund monkeying
Monkeying involves piggybacking the stock picks of some of the better skilled hedge funds in order to generate returns. Among thousands of hedge funds, there are several that manage to outperform the market due to some particular skills of their managers. In this way, by following the activity of these hedge funds, the chance of having positive returns from an investment is possible.
However, the return is not the only metric that should be taken into account in “monkeying,” as there is the market risk of each hedge fund, or alpha; a positive alpha indicates true investing skill. You can learn more about this hedge fund strategy here.
Anticipation of future company-specific events
Since hedge funds sometimes achieve returns based on speculation, the anticipation-based strategy is very common. For example, a hedge fund can invest in a company that is reporting losses, expecting that it will bring higher profits in the future, or in a company that can be purchased by another company at a price that exceeds the current value of a company’s share capital.
We’d classify activist investing under this category, as investors like Dan Loeb (pictured left) and Carl Icahn attempt to convince the companies they’re invested in to undertake value creation methods like a dividend hike or a stock repurchase program.
However, this strategy involves a certain amount of risk (hence the surfboard), and if the anticipation of the event fails, with a significant amount invested in the company, the hedge fund may bear large losses.
Price arbitrage is considered by some to be one of the safest strategies of all, because it does not involve any anticipation or forecasting of future events. Arbitrage is basically obtaining profits from a price difference in two different markets.
Let’s say a hedge fund buys shares of a particular company in the U.S. for $100, and in the meantime, the share price of the same company amounts to $101 (converted USD) in Europe. In this way, by re-selling shares bought in the U.S in Europe, the hedge sees a return of $1 per share.
However, the computerization of trading has reduced price arbitrage opportunities, but currency and fixed income arbitrage opportunities still exist.
Value investing is one of the first strategies adopted by hedge funds, as it was brought to the mainstream by the famous Benjamin Graham and Jerry Newman, the former being the mentor to Warren Buffett.
Any value investing strategy involves the purchasing of undervalued securities. A derivation of this strategy is the long/short strategy, which involves short selling stocks that are considered overvalued by a manager, and purchasing undervalued stocks.
Different value investors–like Irving Kahn (pictured left) or Joel Greenblatt–have different ratios that they prefer to indicate if a company is undervalued, but metrics typically range from the P/E ratio, to the PEG ratio, to the P/B ratio.
The P/E measures how investors are valuing a stock based on its earnings, while the P/B factors how price is related to book value. Both ratios have trailing or forward iterations, the latter of which is used by some, but not all, investors instead of backward-looking metrics.
The PEG ratio, on the other hand, factors expected earnings growth into the equation, and attempts to normalize a stock’s valuation based on the rate at which a company’s bottom line is growing. Ratios like the PEB and even PEC (C = cash flow per share) are more exotic, but have the same basic meaning.