Hedge Fund 101 – The Ultimate Guide to Hedge Fund Trading Strategies
For any high net worth individual looking for somewhere to invest at least a portion of their money, a hedge fund is a logical choice. These can become highly profitable investment vehicles when managed carefully and, to do this, hedge fund managers use a number of trading strategies that we'll go on to examine so you can learn from them too.
But first, a little about the history and nature of hedge funds. The very first of these was launched as an experiment as long ago as 1949 by a man called Alfred Winslow Jones through his business A.W. Jones & Co. He wanted to explore whether it would be effective if he balanced the holding of long-term investments with short-selling other, poorly performing, stocks. He also used leverage to increase potential returns and introduced the concept of a percentage-based incentive fee for the partner managing the fund.
Despite his early success, it wasn't until the 1990s that hedge funds really took off as more and more money managers began to see that they had greater appeal than mutual funds and, in 2019, it was estimated that there were around 10,000 in existence with around $3.25 trillion under management.
What are Hedge Fund Strategies?
The term hedge fund comes from the fact that their managers can hedge their position by trading both long and short so, in theory, profits can be made whichever way the market is moving.
The description of a hedge fund might sound like a mutual fund, and it's true that they share many similarities. Both aim to generate returns for investors while minimizing the risks involved. But they are very different in nature. Hedge fund strategies are seen as being more aggressive and less risk-averse. Generally, they also have higher investment requirements. In the next few paragraphs, we will proceed to discuss the most popular hedge fund strategies.
Before that, however, did you know that you can also trade long and short on different markets - just like hedge funds can? Both retail and professional traders can use Contracts for Difference (CFDs). Essentially, this product allows users to speculate on the price direction of a given market, without owning the underlying asset. This means you could potentially profit from both rising and falling markets.
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The most popular Hedge Fund Strategies
Of the many strategies listed here, most fund managers use a combination in order to generate the best returns, adapting their approach in line with general market conditions.
Funds that are run along a market-neutral strategy are similar in many ways to long/short equity ones in that they don't rely on overall market performance for success. Rather, they aim to neutralize the effects of a volatile market by balancing long and short investments equally – hence the "neutral" in their title. This strategy also uses leverage in some circumstances to increase performance and returns.
This is the closest form of investment strategy to traditional mutual funds. Managers who use this strategy are generally taking a longer-term approach, which is relatively risk-averse. Compared with other investment strategies, it tends to generate lower returns. This, as well as the fact that there is a great deal of competition in this particular field, means that hedge fund managers who adopt this approach need to work particularly hard and produce impressive results to justify the fees that they charge.
On the other hand, the short-only equity approach aims to profit from short-selling stock that is expected to fall in price as time goes on. The skill lies in identifying companies that may be showing signs of distress that have been overlooked by other investors. It also relies on there being an overall bear market. This is an approach that can prove to be very profitable if events go as expected, but it is also a relatively high-risk approach and not for the faint-hearted fund manager.
Short-only hedge funds are also 'event-driven'. For example, in 2020 the impact of the coronavirus wreaked havoc on many different industries. One industry that was hit particularly hard was airlines. Below is a long-term weekly chart of Deutsche Lufthansa's (LHA):
Source: Admiral Markets MetaTrader 5, #LHA, Weekly - Data range: from 2 June 2013 to 2 June 2020, accessed on 2 June 2020 at 1:40 pm BST. Please note: Past performance is not a reliable indicator of future results.
The airline's share price not only show the coronavirus-led market sell-off but also that the company was struggling well before the impact of Covid-19 gripped the markets in 2020. In fact, the airline's share price was already falling from the beginning of 2018 as more low-cost carriers saturated the market. It's these type of event-driven moves hedge funds aim to seek out.
This is arguably the most commonly used strategy and was the one that Jones started back in 1949. The principle is a brilliantly simple one: the chance to win on both investments that rise and fall. It's a question of taking a long position on the companies or commodities expected to do well and choosing another company, often in the same sector, with less favourable prospects and taking a short position on it. This is similar to pairs trading and not only maximises the chances of success, but it is also a fairly effective method of minimizing risk.
However, the long/short equity portfolio is also a great way to hedge exposure. If there happens to be a significant market event which causes global stocks to rally or fall, then at least one investment would be potentially in profit, thereby hedging out the potential loss of the other investment.
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This means you could potentially buy the stock of a company that you think might do well, while shorting the stock of a company you think may not do well. The aim is to hedge out your exposure (hence the term hedge-fund!).
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Credit Structure Arbitrage
Credit structure arbitrage is an important part of the great majority of hedge fund strategies. In it, fund managers search for opportunities to exploit the relative values between different securities from the same corporate issuer. They also look for securities that have the same credit quality, for example, those that are backed by mortgages or are in the form of collateralised loan obligations.
Because it focuses on credit rather than interest rates, this strategy tends to do best when the economy is growing rapidly and borrowing is at peak levels. In order to hedge against economic decline, many fund managers using credit structure arbitrage sell short on interest rate futures and treasury bonds.
In convertible arbitrage, a hedge fund manager decides to buy both a proportion of the convertible debt of a company in the form of a bond as well as equity in the company itself on a short-selling basis. The idea is that these two sides of the investment balance each other out as the market fluctuates. It's a system that thrives when the market is volatile as this presents more opportunities to make trading profits. However, it can be undone when outside events such as takeover bids occur, causing unexpected movements in the value of the stock element of the investment.
Fixed Income Arbitrage
This strategy shares a great deal in common with long and short equity funds as it works by exploiting the differences in value between a pair of fixed-income securities. These can include municipal and corporate bonds as well as default swaps. These are bought in one market and sold in another with profits being made on the discrepancy in prices. As these sales tend to yield relatively modest profits, high levels of leverage are often used. While this increases the potential of generating more profits, it also introduces a fairly high level of risk in the process, which can create losing investments faster.
This is also sometimes known as merger arbitrage, a name that gives a clearer idea of its nature. It involves trading in the stocks of two companies involved in a planned acquisition or merger. This works because, while news of a merger often raises the share price, trading is likely to be at a lower level than the offer price due to the lack of certainty that the deal will actually go through. Profits can be made thanks to this discrepancy, but fund managers need to be highly versed in the regulatory approval landscape to make confident investment decisions of this kind.
The global macro approach is one in which macroeconomic trends and fundamentals are studied in order to try to predict the effects they will have on interest and exchange rates, commodities or equities from all around the globe. The funds themselves can trade virtually anything but tend to focus on derivatives, futures and currencies. They can also be highly leveraged to maximise potential profits.
Traditionally, many hedge funds would look towards the currency and commodity market for global macro plays. With the currencies, the concept was simple - buy an appreciating currency against a depreciating currency. Typically, these macro moves would be event-driven. This includes intervention from central banks or a significant change in an economy's political or economic fundamentals.
For example, the long-term weekly chart below is of the US dollar against the Brazilian Real (USDBRL).
Source: Admiral Markets MetaTrader 5, USDBRL, Weekly - Data range: from 30 October 2011 to 2 June 2020, accessed on 2 June 2020 at 3:40 pm BST. Please note: Past performance is not a reliable indicator of future results.
In the chart above, the Brazilian Real has been falling against the US dollar since 2011, although there was a period of strength from 2015 to 2017. A failing political leader and a stumbling economy caused a huge run on the country's currency. In fact, the currency pair has stayed about its weekly 200-period exponential moving average since 2011. These are the kind of long-term moves hedge funds look for.
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Sometimes also called event investing, this happens when an occurrence creates a shift in a company's value making it an attractive proposition. This can range from the positive, such as a proposed acquisition or a product breakthrough to the negative like a shortfall in projected earnings or the departure of one or more of the senior management team.
When a company is in deep financial trouble it makes for an appealing, if slightly risky, the potential for investment. Distressed investing consists of buying an interest in loans and other debt in the form of bonds, and even stock if the price is right. The advantage of this approach is that all purchases can be made at a big discount – but success depends on the company getting through its troubles in the longer term.
Investments made on the basis of a quantitative strategy use statistical and mathematical modelling whose aim is to identify and predict patterns in the financial world. They rely on processing large amounts of data which are then manipulated using complex processes. In many cases, investment decisions are made automatically and without human intervention. This tends to favour high-frequency trading patterns that are often made using algorithms driven by Artificial Intelligence.
Investing in the world's emerging markets is a popular strategy as they tend to be more volatile than established markets, thus offering the potential for gains. Emerging markets offer a number of different opportunities ranging from bonds to sovereign debt and from currency trading to equities in private companies. The Far East, including countries like Japan, China and Taiwan, is an area of particular interest to hedge fund managers at the moment.
Did you know that with Admiral Markets you can trade and invest into a wide variety of different emerging market indices, currencies and ETFs? You can learn more in the 'Emerging Markets Index Investing' article.
Why use Hedge Fund Strategies with Admiral Markets?
As we've seen, there is a wide number of strategies used by hedge fund managers intended to bring financial rewards for the investing partners. Before committing to any particular hedge fund style, it's important to carefully examine both the benefits and risks to using a particular strategy and the resources you have available to you.
Of course, the key to any hedge fund strategy is market timing. This can be difficult for beginner traders, as well as market veterans! However, Admiral Markets offers users the ability to upgrade their MetaTrader 5 trading platform to the Admiral Markets Supreme Edition completely FREE, to receive the Technical Insight Lookup indicator.
This indicator allows users to search actionable trading ideas across a wide variety of markets, providing short-term, intermediate-term and long-term technical analysis events. An example screenshot is shown below.
An example screenshot of the Technical Insight Lookup indicator provided by the Admiral Markets Supreme Edition package for MetaTrader 5.
In the above example, the indicator searches for all the different technical analysis events for a given market which for above is the VanEck Vectors Gold Miners ETF. This could be a great tool for traders searching for trading ideas across a wide variety of different markets. You can learn more about this indicator in the 'How to Trade with Trading Central' article.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer or solicitation of any transaction in financial instruments. Please note that this trading analysis is not a reliable indicator of current or future performance as circumstances may change over time. Before making any investment decisions, you should seek independent financial advisors to help you understand the risks.