Introduction to Hedge Funds

Hedge funds are special funds that incorporate unique investing strategies in order to achieve excess returns for their investors. They analyze the market opportunities and hope to utilize the opportunities to outperform the entire market. There are several types of specific strategies that most hedge funds might practice in their portfolio construction, and in this article, some will be listed.

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Long and Short Equity

The first hedge fund used a long and short equity strategy. It was first practiced by Alfred W. Jones in 1949. The core concept behind this strategy is simple. The stock market at its foundation is a “binary system” with only two potential results: gain or lose. The two results often correspond to the two reactions investors take: long and short (Long and Short Positions). So, if an investor is certain about his intuition and hopes to raise his net return, he can choose to apply a long and short equity strategy.

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The specific actions for the investor to take are also simple. For example, if he believes Nike is considered undervalued relative to Adidas, a good choice for him is to buy $10,000 worth of Nike’s shares and short the same amount of Adidas’s share. In the best-case scenario, if the investor’s forecast is absolutely correct (which means Nike increases in value and Adidas drops), the investor will maximize his return. Even if his forecast has a certain error, and both Adidas and Nike increase in value, he will still profit as long as Nike increases more than Adidas.

From a risk-management perspective, long and short equity is an optimal strategy compared to a merely long (or short) strategy, because it balances the risk by incorporating two opposite strategies. Imagine in this way, if a long position is positive and a short position is negative, the combination of long and short equity actually has a net market exposure of zero.

However, similar to other hedge fund strategies, the long and short equity strategy also has risks accompanying it. If the investor’s forecast turned out to be absolutely false, his loss will also be magnified. Therefore, the core behind all hedge funds is the same: Understand your investment thoroughly and be confident with your investment decisions.

Market Neutral

The market neutral strategy is an extension of the Long and Short Equity strategy, as it seeks absolute zero market exposure (a measurement of risk). For certain long and short hedge funds, there might be an unbalanced number of long and short values. Whereas in a market-neutral fund, the amount invested in the long position and the short position must be the same.

In this way, the market exposure will be decreased to zero. But according to the risk-return correlation, the expected return rate of a Market Neutral portfolio will also be less than a merely long portfolio.

Quantitative

Perhaps one of the most popular hedge fund strategies in recent years is to make investment decisions based on quantitative analysis (QA). Quantitative investors and hedge funds are people who hope to analyze stocks using mathematical and statistical models. For most scenarios, quantitative investors will build algorithms using machine learning strategies to launch technologies that can automatically trade stocks.

Under the quantitative analysis strategy, a famous subsection is called high-frequency trading (HFT), which are investors that use models to capture pricing signals and trade frequently on a daily basis.

Noticeably, the quantitative analysis could be extremely risky, especially if the fund or the investors are not confident in the models that they are relying on. This explains why funds applying this strategy are often called “black boxed”. The famous stock market crash in 1987 is primarily driven by excessive auto-trading bots (a type of HFT) in the market.

If you want to learn more and gain more experience in the stock market, check out the stock trading game. You can develop your own investment strategy and experience trading under excessive market conditions!

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Global Macro Strategy

For funds applying the global macro strategy, they make investment decisions based on the macroeconomic trends across the globe, including changes in the interest rate, economic cycles, price level, etc. These funds generally hold a variety of types of investments, including currency, options, stock, and bonds.

The approach is also simple. For example, if an investor believes that the United State will soon enter a period of economic recession because of the continuously increasing interest rate, then he will try to short stocks and other financial assets related to the U.S. indices. On the other hand, if he forecasts that the new monetary policy introduced in Japan is benefiting the stock market, he can buy long positions in Japanese-related stocks.

Dual-Effects on Hedge Funds

Benefits

• As emphasized, hedge funds can often bring excess returns. However, as the return increases, the corresponding risk also increases. It is always important for investors to invest in assets in which they can afford the risk.
• Some types of hedge funds, like the long and short equity strategies mentioned above, are designed to decrease the “overall risk and volatility”.
• Provide all investors with the exposure to advanced investment strategies

Disadvantages

• Many hedge funds implement novel investment strategies that are not tested by the market. This means an extremely high risk to investing in hedge funds like these.