It is widely believed that the first hedge fund was created by Alfred Winslow Jones in 1949. Jones, on assignment for Fortune magazine, was investigating techniques for forecasting the stock market and became fascinated by some of the more unusual trading methods he was researching. He then structured his own investment fund, set it up as a partnership and became the general partner. This structure is important, as it technically made the fund exempt from regulatory control and allowed Jones to utilise investment techniques that were not open to the typical investment manager.

In the time since Jones’s fund, the hedge fund industry has matured and the most commonly employed hedge fund strategies have changed. Most of the early hedge funds were equity long/short funds, as described below. However, over time, as the hedge fund industry grew in size and prominence, many types of strategies began to develop. By 1990, more than 70 per cent of hedge funds were operating macro strategies. In recent years, there has been a shift back to the equity long/short strategy.

There are at least ten primary hedge fund investment strategies in use globally today, and this article seeks to explain four of the most frequently used strategies:

• Equity long/short

• Equity market neutral

• Merger arbitrage

• Macro

Equity long/short

Equity long/short managers look to profit from strong stock selection, either through investing in companies that are likely to outperform (long investing) or selling those that are considered overvalued (shorting).

Managers may specialise in a kind of stock, such as value or growth stocks, small-cap or large-cap stocks. There are many trading styles, with some funds run by frequent or dynamic traders and some by longer-term investors. Typically, equity long/short investing is based on bottom-up fundamental analysis of the individual companies in which investments are made. There may also be top-down analysis of the risks and opportunities offered by industries, sectors, countries and the macroeconomic situation.

A fund manager attempts to reduce volatility by either diversifying or hedging positions across individual regions, industries, sectors and market capitalisation bands and hedging against market risk. There is wide variation in the degree to which managers prioritise seeking high returns (which may involve concentrated and leveraged portfolios) and seeking low volatility (which involves more diversification and hedging).

Equity market neutral

Equity market neutral managers seek to profit from exploiting pricing relationships between different equities while hedging exposure to overall equity market moves. This means that the manager’s portfolio should not be affected by either bear or bull markets and is, therefore, a good strategy to use when diversifying a standard portfolio.

To achieve “market neutrality”, trading managers will typically hold a large number of long equity positions and an equal, or close to equal, value of offsetting short positions. In all equity market neutral portfolios, stocks expected to outperform are held long and stocks expected to underperform are sold short. Returns are derived from the long/short spread, or the amount by which long positions outperform short positions.

Equity market neutral strategies often include a variety of automated trading systems that commonly make use of statistical methods and artificial intelligence techniques. Some use models that analyse and exploit pricing inefficiencies that may develop between various market sectors, while others focus on pairs (or baskets) of equities in the same industry sector that have exhibited a high degree of correlation in their price movements over time.

Merger arbitrage
Merger arbitrage managers seek to exploit the movements in the stock price of companies undergoing mergers. When a merger is announced, there is always a risk that the merger deal will not close within the specified timeframe or, indeed, at all. Managers are able to exploit this uncertainty to make profits.

During a merger involving listed companies, the acquiring company offers to buy the shares of the target company at a proposed price that is usually at a premium to the current market price. As a result, the target company’s shares tend to trade at a lower price than the proposed purchase price until the merger is completed.

To exploit the price change that will occur, merger arbitrage managers buy shares of the target and short sell shares of the acquirer, constructing a trade that will benefit from the closure of the spread between the two share prices at the conclusion of the deal.

Merger arbitrage hedge fund managers demonstrate their skill through analysing the probability of complications that may arise during the merger. These might include failure to obtain shareholder approval or regulatory clearance or an external market event that could affect either party’s willingness to participate in the deal.

Global macro

In 1990, the global macro hedge fund strategy was the most popular hedge fund strategy worldwide, accounting for just over 70 per cent of hedge fund assets. Due to the rise of other strategies and an emphasis on diversification, the macro strategy currently comprises just less than five per cent of hedge fund assets.

Global macro hedge funds aim to generate significant returns from movements in equity, currency, interest rate and commodity markets. The strategy is based on managers’ use of macroeconomic principles to identify dislocations in asset prices. Global macro hedge funds have the widest mandate of all hedge fund strategies, as managers have the ability to take positions in any market or instrument.

Profits are derived from correctly anticipating price trends and capturing spread moves. Macro trades are classified as either directional – where a manager bets on distinct price movements, such as buying sterling against the US dollar or short selling emerging market bonds – or relative value – where two similar assets are paired on the long and short sides to exploit a perceived relative mispricing, such as long Japan equities versus short Emerging Asia equities.