The 9 Different Types Of Hedge Funds You Need To Know
Hedge funds have the potential to generate high returns – here are nine you need to know.
Published on 5 July 2017
Hedge funds were once used to mitigate market volatility by buying overvalued stocks and quickly selling them. These small private partnerships can earn you high returns, but – unlike mutual funds or the stock market – they are unregulated. This means investors in such funds will have to do more research and know their funds well. Here are nine types of hedge funds you need to know.
Fund managers hold both long as well as short positions by buying securities that they expect will perform and short selling the ones that they think will underperform. This is one of the more flexible and balanced strategies in managing a fund. As correlation to overall markets is low, so are the risks. There are two types of long-short funds:
This is often used to hedge against market movements. Although some consider this type of fund to be similar to long-short funds, market-neutral funds differ in that they have the same exposure to bullish and bearish positions (longs and shorts are balanced) – whereas long-short funds tend to tip towards being more long than they are short. As this type of fund aims to be zero beta, they are low-risk.
Convertible arbitrage funds
Another long-short strategy, this type of fund buys convertible securities (usually convertible bonds that can be converted into common stock) of a company and short sells its common stock – which differs from long-short funds that buy and short sell only stocks of different companies.
This type of fund attempts to gain from events that make an impact on market prices – corporate actions, political developments, natural disasters, etc. As the market reacts to news of such events, event-driven funds take advantage of the resulting price inefficiencies to amplify returns.
Macro funds can invest in a wide range of securities – such as bonds, commodities, currencies, and stocks – whose prices fluctuate depending on macroeconomic developments. As this type of fund tends to make bets based on such events – albeit based on research – associated risks are generally high.
Securities of companies that are in distress can be a bargain, but they are also risky as the company may have accumulated a large debt or may potentially face bankruptcy. These securities can be bonds, common stock, trade claims, bank debt, etc. Based on the fact that these companies are in distress and are unable to settle their financial debts, securities can be bought with large discounts. However – if the company does file for bankruptcy – the securities held by these funds will be worthless.
These funds are pretty self-explanatory in that they invest in securities of emerging markets, which are developing countries with low to medium per capita income. These funds tend to be riskier as growth in these countries can be relatively volatile, although returns can be relatively higher too.
As opposed to long-short funds, long-only funds take solely long positions and they focus on stocks with a view to gain from an increase in prices – which is similar to traditional mutual funds. The downside to long-only funds is that they can be pretty risky if they are exposed to a prolonged bearish market.
These funds are the opposite of long-only funds in that they look for potentially bearish market conditions so as to benefit from short selling stocks when prices fall. Similar to long-only funds, this strategy is risky as bets are on the market going only one way.
A variation of convertible arbitrage funds, this type of fund takes advantage of price differences between securities – except that it focuses only on the fixed-income market. This includes securities such as bonds, treasuries, and credit default swaps.
This type of fund buys and sells stocks of companies that are undergoing a merger, which typically causes the target company’s stock price to increase and the acquiring company’s to decline. However, the target company’s stock usually still trades below the offer price as there is uncertainty as to whether the merger will actually occur.
The bottom line
Bearing in mind that there are so many different types of hedge funds out there, it is important to do enough research to find out which fund is right for you – as each fund is very different, each with its own type of risks, specialising in different areas of investment, and performing differently as well.