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Young hedge fund managerHedge funds aim to deliver above-average returns to investors who are interested in owning more than just stocks in their portfolios. It’s the hedge fund manager’s job to determine how pooled money is invested to achieve specific objectives. They do so by employing different hedge fund strategies which help drive returns. Some strategies prove more popular or successful than others and if you’re considering hedge funds as an investment, it’s helpful to know how they compare. Deciding to dive into hedge funds is a decision best made with the guidance and counsel of a financial advisor.

Hedge Funds, Explained

Hedge funds are similar to traditional mutual funds, in that they’re pooled investments. What’s different is who can invest in them and how they approach the market.

Most often, only accredited investors are eligible to join a hedge fund. These are individuals who meet income or net worth standards established by the Securities and Exchange Commission. The exception to the rule is hedge fund ETFs or exchange-traded funds. It’s possible to invest in a hedge fund ETF, which can mimic hedge fund strategies, without being an accredited investor.

In terms of how hedge funds work and what they seek to do, the goal is to offer investors returns that outpace the market. While a typical mutual fund may hold a mix of stocks and bonds, hedge funds can expand their reach to include alternatives such as land, real estate, derivatives or currencies. Hedge funds can be riskier than regular mutual funds but they can yield significantly higher returns if the hedge fund manager’s strategy pays off.

Common Hedge Fund Strategies

There are multiple strategies hedge fund managers can use when determining how to invest to generate higher rates of return. Each one can carry a different risk/rewards profile and/or adhere to a different investment philosophy. That’s important to keep in mind if you’re considering hedge funds or hedge fund ETFs to ensure that the one you choose matches up with your own investment style.

With that in mind, here are some of the most common hedge fund strategies fund managers may apply.

Long/Short Equity

Long/short equity is one of the simplest hedge fund strategies to understand. In this scenario, a hedge fund manager would take long positions in companies that are set to perform well while shorting equities that are likely to underperform.

To make this strategy work, a hedge fund manager needs to accurately guess which stocks will rise in price and which ones will decline in price. This type of strategy has lower market correlation so it offers better return potential if those guests prove correct.

Market Neutral

Market neutral hedge fund strategies are similar to long/short equity in some respects, in that performance usually has a low correlation to the market. The difference is that a market neutral approach seeks to minimize or eliminate volatility altogether by reducing correlation to 0.

A market neutral strategy isn’t as risky as a long/short equity strategy. But because it emphasizes holding equal short and long positions, the return potential is lower.

Arbitrage

Hedge funds that use an arbitrage strategy aim to capitalize on price differences between investments that are closely related. Arbitrage strategies can help reduce risk while generating stable returns but there is potential for losses if hedge funds rely too heavily on leverage to execute them.

There are different ways hedge funds can apply arbitrage strategies. For example, merger arbitrage allows hedge funds to take advantage of pricing shifts that can happen prior to and following a merger. With fixed-income arbitrage, the goal is to take advantage of pricing differences across different fixed income securities, such as bonds. Convertible arbitrage means taking long positions in a company’s convertible securities while shorting its common stock.

Each of these strategies may pose more risk than long/short equity or market neutral strategies.

Credit

Hedge fund bookSome hedge funds base their investment decision-making around credit and lending. For example, a hedge fund may focus its attention on investments in distressed debt. When companies are struggling financially, that creates an opportunity to buy up their debt at discounted values. This includes buying bank loans and other high-yield debts.

Hedge funds that use credit strategies may also focus on fixed-income investments as well. For example, this can include things like corporate bonds or debentures, which are uncollateralized bonds. Fixed income credit strategies tend to be less risky than distressed debt investing.

Event Driven

Event driven hedge fund strategies are what they sound like: hedge fund managers seek to invest based on specific events that can impact a company’s pricing and profitability. For example, that can include things like mergers or acquisitions, internal reorganization, bankruptcy filings or anything else that can trigger price fluctuations.

Some of the strategies mentioned previously could technically be included under the event driven umbrella. For example, distressed debt strategies or merger arbitrage strategies could both qualify as event driven investing.

Quantitative

When hedge fund managers apply a quantitative strategy it means they’re using quantitative analysis to form investment decisions. This type of analysis involves using mathematical formulas and statistics to draw conclusions about how a particular investment may perform.

Quantitative hedge fund strategies are more complex than other strategies and offer less transparency to investors. This is because hedge funds that utilize this approach may implement proprietary algorithm-based modeling to conduct quantitative analysis.

Global Macro

Hedge funds that follow a global macro strategy are primarily concerned about how macroeconomic trends will affect investments on a worldwide scale. Specifically, that includes looking at how things like interest rate policy, economic policy or political events may create opportunities for investment.

These funds can be diverse, with investments ranging from stocks and bonds to commodities or foreign currencies. Compared to other hedge fund strategies, global macro can be more volatile and present a higher risk to investors.

How to Choose Hedge Funds to Invest In

Stock chart

If you’re interested in adding hedge funds or hedge fund ETFs to your portfolio, understanding which strategy a specific fund follows is important. This can help you gauge whether the fund is a good match for you, based on your risk tolerance and investment goals. It’s also important to keep in mind that some hedge funds may use a multi-strategy approach, in which different strategies are applied simultaneously. These funds may produce consistent or stable returns while minimizing the amount of risk involved for investors.

As you compare hedge funds or exchange-traded funds that engage in hedging strategies, pay attention to the basics the same as you would with any other type of mutual fund or ETF. That includes understanding the fund’s makeup and investment strategy, its historical performance and how much you’ll pay to own it. Reading through a fund’s prospectus can help but you may want to ask your financial advisor for their input before committing to a particular fund.

The Bottom Line

You may seek out hedge fund investments if you’re comfortable taking more risk in your portfolio to realize higher returns. It’s important to understand that while hedge fund strategies can share some similarities they aren’t all identical.

Tips for Investing

  • Hedge fund ETFs can be an attractive alternative to traditional hedge funds for several reasons, starting with lower minimum investment thresholds. While you may need tens or even hundreds of thousands of dollars to buy into a hedge fund, you may be able to invest in hedge fund ETFs with much less money. Opening an online brokerage account is one way to gain access to hedge fund ETFs.
  • Consider talking to a financial advisor about whether hedge funds are something you should be considering in your investment plan. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect quickly with professional advisors in your local area. If you’re ready, get started now.

Photo credit: ©iStock.com/andresr, ©iStock.com/designer491, ©iStock.com/G0d4ather

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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