If we are to believe the popular press Hedge Fund Managers are among the robber barons of our age. The term Hedge Fund is generic term that is often misunderstood and misused. Just like mutual funds that come in different types and categories like bonds, equities, international, etc. hedge funds do as well. To understand hedge funds an investor needs to understand that the category is also made up of a variety of different strategies and purposes and that these differing strategies have little in common with one another.
Hedge funds do not constitute a homogeneous asset class. The bulk of hedge funds describe themselves as long / short equity, perhaps because this is the least specific of the available descriptions, but many different approaches are used taking different exposures, exploiting different market opportunities, using different techniques and different instruments.
- Global macro – seeking related assets that have deviated from some anticipated relationship.
- Arbitrage – seeking assets that are mis-priced relative to global alternatives.
- Convertible arbitrage – between a convertible bond and equity.
- Fixed income arbitrage – between related bonds.
- Risk arbitrage – between securities whose prices appear to imply different probabilities for an event.
- Statistical arbitrage (or ‘StatArb’) -between securities that have deviated from some statistically estimated relationship.
- Derivative arbitrage – between a derivative security and the underlying security.
- Long / short equity – generic term covering all hedged investment in equities.
- Short bias emphasizing or investing solely short.
- Equity market neutral – maintaining a close balance between long and short positions.
- Event driven – specialized in the analysis of a particular kind of event
- Distressed securities – companies that are or may become bankrupt
- Regulation D – distressed companies issuing securities
- Merger arbitrage – between an acquiring public company and a target public company
The reason many lump the term hedge funds into a single category has more to do with the organizational structure and how the hedge fund managers are paid than the commonality of the above strategies. There are many good reasons to use hedge funds. To use these strategies an investor needs to meet the accredited investor standards put forth by the SEC. This means that individuals need to have a net worth of over a million dollars to be able to participate.
Over time we will explore other issues with doing fund due diligence and why a certain strategy may be employed in a situation. Stay tuned!