Hedge Fund Strategies

While we find it highly unlikely that our readers will be investing in hedge funds anytime soon (after all, the minimum investment is usually $250,000), they're still interesting things to learn about.

Like mutual funds, there are a variety of different hedge fund classifications.  Each fund has its own strategy that it uses to try and earn a high return on investment for its investors.  Each of these strategies varies in the types of returns they generate and in their expected volatility, as you are about to see.

Aggressive Growth Volatility: HighAggressive growth hedge funds typically take an aggressive approach to investing by buying stocks with high P/E multiples and shorting stocks that are likely to miss their earnings estimates. They're usually biased towards investing in companies in the technology and biotechnology sectors.

Distressed Securities Volatility: ModerateThese funds buy equity or debt in companies that are facing bankruptcy. These fund managers usually think that the general public doesn't understand troubled companies very well so they seek to profit from deeply discounted securities.

Emerging Markets Volatility: Very HighEmerging market funds invest in stocks or bonds of emerging markets.  These are considered very volatile because emerging markets typically have higher inflation and volatile economic conditions. Not all emerging markets allow short selling so hedging is usually not available.

Income Volatility: LowHedge funds with a focus on income usually focus on high-yield stocks or bonds. They also might purchase fixed income derivatives that enhance their profit from the appreciation and interest income.

Macroeconomic Volatility: HighMacroeconomic funds aim to profit from changes in global economies. They are typically involved in stocks, bonds, commodities, and currencies.  These funds usually use derivatives to increase the impact of market movements.

Market Neutral Volatility: LowMarket neutral funds attempt to remove the market risk from their portfolios by being both long and short in a given sector.  A market neutral fund may pick two similar stocks and purchase the one it feels is better and short the stock that is weaker, hoping that the stock it likes more outperforms the other stock.

Opportunistic Volatility: DependsThese types of hedge funds often vary their investment strategies to whatever conditions they feel are profitable at the time.  For example, if the IPO market is hot, they may attempt to buy in on a large number of IPO's.  Or they will be involved in hostile takeovers.

Short Selling Volatility: Very HighShort selling funds short all of the investments in their portfolio.  These funds often come into favor when people feel the market is about to approach a bearish cycle.  However, since short selling a stock exposes the investor to an unlimited amount of risk, these funds are often seen as very risky.

Special Situations Volatility: DependsSpecial situation hedge funds invest in event-driven situations such as mergers, hostile takeovers, bankruptcies, or leveraged buy outs.  Many of these funds will buy stock in the company being acquired and sell or short the stock in its acquirer.  These funds' results usually aren't dependent on the direction of the overall market.So as you can see, there are a number of different strategies hedge funds can use.  If you want to read a good book about how a hedge fund can enjoy amazing success and then squander it all away, we recommend you check out "When Genius Failed."