A hedge fund is an alternative investment that pools capital from accredited individuals to speculate and uses diverse strategies to earn active alpha or return for the investors. To achieve a greater return on capital, hedge funds utilize different strategies and investing styles. All the fund types generally fall into five categories which include macro, event-driven, arbitrage, long/short and tactical trading. Here are the 9 common types of hedge funds that you need to know:
1. Convertible Arbitrage
This is a long/short equity strategy that buys convertible securities of the company and short sells the ordinary stock of the same company. The convertible security is usually a convertible bond that can be converted into common stock at some point in the future.
2. Long-short Equity Funds
This is one of the most flexible types of funds that allow the manager to hold a long as well as a short portfolio. Fund managers purchase the stock of the companies they anticipate to outperform and then short sell the stock of the companies they expect will fall in price or underperform.
3. Event-Driven Fund
The event-driven investing style is a strategy which is more open to interpretation due to a wide variety of events that can occur. The news of event such as an IPO, a merger, an acquisition, a spin-off among others can cause price inefficiencies to occur before and after such events. These price inefficiencies are what the fund managers attempt to take advantage to boost the fund's return.
4. Macro Funds
These are diverse types of funds that can invest in stocks, bonds, currencies, and commodities. They search for global opportunities and tend to invest in situations created by changes in the government policy, interest rates, and economic policy. These funds tend to use derivatives and can be significantly leveraged.
5. Distressed Securities Funds
This fund involves buying stocks of companies that are in distress, restructuring and those facing potential bankruptcy. These securities are usually in form of bonds, trade claims, bank debt, preferred or common stock. The securities in most cases are sold at deep discounts and so fund managers take advantage of that.
6. Emerging-Market Funds
The fund invests in the emerging market or the developing countries and the companies that are within these markets. The growth in emerging economies tends to be more volatile and is likely to face high inflation rates.
7. Fixed-Income Arbitrage Funds
The fund attempts to take advantage of price differences between two securities which are usually done in fixed income market only. The securities involved include corporate bonds, treasuries, municipal bonds, or even credit default swaps. This is a winning strategy but with minimal gains and loss is less frequent.
8. Merger Arbitrage
These funds are a sub-section of the event-driven funds. The fund buys and sells the stocks of two merging companies simultaneously. In a merger event announcement, the price of the stock of the company being acquired jumps in price but usually trades below the offer price due to the uncertainty of whether the merger will occur or not. The stock of the acquiring company tends to drop in value if the transaction involves an exchange of stock.
9. Market Neutral
These funds are almost similar to equity long-short funds as they seek returns that are fully independent of the market performance. The funds one strategy is holding equal long and short positions within the same sector, a strategy that places emphasis on stock selection an analysis. These funds tend to eliminate market volatility. They may use derivatives to hedge the entire portfolio and use leverage to enhance returns.