There are many kinds of funds, ranging from illiquid private equity funds to highly liquid mutual funds and ETFs that are available to the public. Hedge funds occupy the sweet middle, but what are hedge fund trading strategies?
Hedge fund trading strategies are an investment pool contributed by a limited number of private investors and operated by a professional manager with the goal of maximizing returns and minimizing risk. Hedge fund investment is often considered a risky alternative investment choice and usually requires a high minimum investment. So, they are meant for accredited investors and institutions.
In this post, we take a look at hedge funds and their strategies and how you can make your own “one-man hedge fund”. At the end of the article, we show you some real results, examples, and backtests of hedge fund trading strategies.
What is a hedge fund?
A hedge fund is an investment pool contributed by a limited number of private investors and operated by a professional manager with the goal of maximizing returns and minimizing risk. Hedge fund investment is often considered a risky alternative investment choice and usually requires a high minimum investment or net worth. So, those who can invest with hedge funds are accredited investors and institutions. A hedge fund is strictly regulated.
Hedge funds trade in relatively liquid assets and are able to make extensive use of more complex trading, portfolio construction, and risk management techniques in an attempt to improve performance, such as short selling, leverage, and derivatives. Their ability to use leverage and more complex investment techniques distinguishes them from regulated investment funds available to the retail market, such as mutual funds and ETFs.
Hedge funds are considered distinct from private equity funds and other similar closed-end funds because they generally invest in relatively liquid assets and are usually open-ended — investors are allowed to invest and withdraw capital periodically based on the fund’s net asset value, whereas private-equity funds generally invest in illiquid assets and only return capital after a number of years.
A unique feature of almost all hedge funds is their aim to maintain a neutral market direction so they can make money despite the direction the market is taking. This is where they got their name from — hedging (holding both long and short stocks to minimize risks and make money despite market fluctuations). However, hedge funds have many different kinds of structures and employ different strategies.
List of the most common hedge fund strategies
Although hedge funds are based on the same principles, they can be very different from each other with respect to their strategies. Here are some of the most common strategies used by hedge funds:
- Long/Short Equity Strategy: One of the most commonly used strategies, the long/short equity strategy involves taking long and short positions in equity and equity derivative securities.
- Short-Only Strategy: This involves short-selling the shares that are anticipated to fall in value. The strategy requires serious research to find companies that are in serious trouble.
- Momentum Strategy: This involves buying the best-performing stocks and shorting the worst ones. The idea is to ride the momentum of rising and declining stocks.
- Credit Funds Strategy: This refers to making debt investments based on lending inefficiencies, such as distressed debt. It also includes other fixed-income debt investments.
- Merger Arbitrage: This involves taking opposing positions in two merging companies to take advantage of the price inefficiencies that occur before and after a merger.
- Convertible Arbitrage: This involves taking long positions in a company’s convertible securities and, at the same time, taking a short position in a company’s common stock so as to profit from price inefficiencies of a company’s convertible securities relative to its company’s stock.
- Capital Structure Arbitrage: This strategy aims to profit from the pricing inefficiency in a firm’s capital structure by buying the firm’s undervalued security while selling its overvalued security.
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- Fixed-Income Arbitrage: This aims to profit from arbitrage opportunities in interest rate securities. For example, taking opposing long and short positions in a swap and a Treasury bond.
- Event-Driven: This implies investing in opportunities that arise in response to specific corporate events, such as mergers and takeovers, reorganizations, restructuring, asset sales, spin-offs, bankruptcy, and other events creating inefficient stock pricing.
- Quantitative Strategies: These make use of technology-based algorithmic modeling to achieve desired investment objectives. They rely on quantitative analysis to make investment decisions.
- Global Macro strategies: This refers to the general investment strategy that is based on the broad political and economic outlooks of various countries. It is not confined to any specific investment vehicle or asset class. Investment can be in equity, debt, commodities, futures, currencies, real estate, and other assets in various countries.
- Multi-strategy: This involves the use of a variety of investment strategies. Funds that use this method are not married to a single investment strategy or objective. The aim is to achieve positive returns regardless of overall market performance. This strategy has a low-risk tolerance and maintains a high priority on capital preservation.
How do hedge funds develop trading strategies?
Hedge funds invest in a wide variety of financial instruments using different strategies and risk management techniques. They are run by professional managers who, together with their team of analysts, develop strategies that are suitable for the funds based on their goals and objectives.
Some hedge funds will have multiple strategies and be diversified among many strategies, managers, and investments, while others may take highly concentrated positions or may only use a single strategy. Whatever the approach, most hedge funds use either quantified (systematic) strategies or discretionary strategies. But some may combine both in a diversified approach.
Hedge funds strategy development follow the same approach as other investors. Generally, the steps involved in developing a strategy include:
- Research: The first step in strategy creation is researching the markets to find trading edges. This includes going through academic financial journals to find any recurring inefficiencies observed in the market.
- Defining the trading rules: Here, the edge is converted to a strategy by stating the criteria for trade entry and exits and other risk management parameters.
- Backtesting and optimization: To know whether the strategy holds any promise, it is backtested on historical price data and optimized as necessary. This tells them how the strategy would have performed if it was deployed in the past.
- Forward testing: A strategy that performs well in backtesting is tested in the current market via paper trading to know whether it still works in the current market conditions.
- Strategy deployment: If the strategy does well in the current market condition, it can be deployed to trade real money.
- Monitoring and evaluation: After a strategy is deployed, it is monitored and evaluated from time to time to know if it is still profitable or needs to be tweaked. Trading is a constant feedback loop.
What is a niche hedge fund strategy?
Although most modern hedge funds invest in a wide variety of financial instruments using different strategies and risk management techniques, some funds are focused on specific niches and are called niche hedge funds.
A niche hedge fund strategy is one that concentrates on a specific, small market niche, such as real estate, cryptocurrency, insurance-linked instruments, and so on.
A real estate-focused hedge fund invests exclusively in the real estate market. Some of the assets this kind of hedge fund invests in include housing, hotels, and commercial properties.
Insurance-linked niche strategies are linked to different forms of underlying insurance-related risk, such as life/longevity products, natural catastrophes, or industry loss, with little-to-no correlation to capital markets.
Recently, there has been a lot of interest in the cryptocurrency market, and there are some crypto niche hedge funds. Such funds invest directly in either cryptocurrencies or crypto-related securities and typically use strategies such as long-only buy and hold, initial coin offerings (ICO), and active trading through shorting, futures, and relative value trading.
Hedge fund strategies examples
As we stated above, there are many different strategies hedge funds use to make money from the market. Here, we will show a few examples to show how the long/short equity strategy and the merger arbitrage work.
Long/Short Equity Strategy
Here, the hedge fund maintains long and short positions in stocks and their derivatives by buying stocks that are undervalued and selling those that are overvalued.
For example, If Apple looks undervalued while Microsoft looks overvalued, the fund may buy $1,000, 000 worth of Apple shares while shorting an equal value of Microsoft shares. The net market exposure is zero in such a case, but the expectation is that Apple shares will rise to meet its real value and that Microsoft shares will fall. But even if bought rises or falls, the fund will still make money if Apple outperforms Microsoft.
Supposing Apple rises by 27% and Microsoft rises by 20%, the fund sells Apple for $1,270, 000, which covers the Microsoft short for $1,200,000, and it pockets $70,000 profit.
On the other hand, if Apple falls 23% and Microsoft falls 30%, the fund sells Apple for $770,000, which covers the $700,000 needed to buy back Microsoft. So, it still pockets $70,000 profit.
Merger Arbitrage Strategy
Here, a fund manager takes opposing positions in two merging companies to take advantage of the price inefficiencies that occur before and after a merger.
For example, let’s say Company A is trading at $20 per share Company B wants to buy it at $30 per share. If a hedge fund manager gets Company A stocks at say $25 and holds till after the merger and sells at $30, they would pocket about $5 per share.
Hedge Fund Trading Strategies (Backtests And Examples)
Your aim as a trader should be to trade like a one-man hedge fund. What do we mean by that? Let’s explain:
One-man hedge fund
First of all, you need to treat it like a profession. Be meticulous, have plans, have a trade journal, and you need to have a trading account that lets you trade different assets. To be frank, if you have little capital and are not able to make any meaningful diversification, perhaps you should not trade, but invest.
You need to have a decent size of your trading account. How much? Probably more than you’d like (or have?). But in order to succeed at trading, you need more than a tiny 10 000 account. Those with small trading accounts tend to gravitate toward forex only to lose it all within a short time period.
When we were proprietary traders we traded very much like a one-man hedge fund. You can read more here:
How to develop a hedge fund stragy
There is no typical hedge fund trading strategy. However, you need to think somewhat like this:
- You need a trading idea – an idea for a strategy. There are many ways to get trading ideas.
- When you have an idea, you need to backtest it to see if it works or not. (What is backtesting?)
- If the backtest is successful and it shows some promise, you must find the trading universe for the strategy. Then backtest out-of-sample.
- If it only works for one asset, that is also fine. No strategy works on all asset classes.
- If you are going to use the strategy on several assets, you must find the right weightings for each asset.
- After looking at weightings, you have to look at risk management.
- The most important risk metric is correlation. What’s the correlation to your other strategies?
- Last, you must incubate or paper trade the strategy for a few months. If it goes well, then execute it and trade it.
Simple in theory, but not so easy in practice!
We have previously made a couple of profitable trading strategies that could potentially be turned into hedge fund strategies. Many hedge fund strategies can be labeled trend following. These can be systematic, meaning what we do on this website (quantified strategies), or discretionary. The latter means they are executed by the fund manager while the former most likely are executed automatically by a computer.
Hedge fund strategies – correlation
As mentioned, perhaps the most important thing for a hedge fund is to have strategies that complement each other. This can’t be stressed enough. The chart below shows the importance of this:
The chart shows the performance of Brummer & Partners’ Multi-strategy fund (the red line), while the grey line is the MSCI World Index.
Obviously, the red line is the preferred line for most traders and investors. The grey line might have a somewhat higher return, but you suffer some heavy drawdowns along the way. Most hedge funds look for the path of the red line.
How can you achieve such a smooth return?
You need to invest in strategies that are different. You can’t look at the performance of each separate strategy, and just add them to your portfolio. How they correlate with each other is more important. Even strategies that on their own are not particularly good, can be extremely valuable if it’s uncorrelated to the other strategies. Even a “mediocre” strategy adds a lot of value if the correlation is low to the other strategies or funds.
Thus, when making backtests, the correlation is often more important than the performance.
List of trading strategies
Since this blog’s inception back in 2012, we have written more than 800 articles. Many of those articles contain strategies (including this article), and we have compiled many of those into a package of code that you can order. We have thus far over 160 different strategies in our compilation.
The strategies also come with logic in plain English (plain English is for Python traders).
For a list of the strategies we have made please click on the green banner:
These strategies must not be misunderstood for the premium strategies that we charge a fee for:
FAQ (frequently asked questions) hedge fund strategies
Let’s end the article with a few typical frequently asked questions about hedge fund strategies:
Q. What are the most common types of hedge fund strategies?
A. The most common hedge fund strategies include long/short equity, event-driven, global macro, relative value, and fixed income arbitrage.
Q. What are the advantages of investing in a hedge fund?
A. The advantages of investing in a hedge fund include the potential for higher returns, diversification, access to professional managers, and the ability to access unique investments.
Wealthy people invest in hedge funds to offset the risks from equities. It’s all about diversification.
Q. What is the minimum investment required to invest in a hedge fund?
A. The minimum investment required to invest in a hedge fund typically ranges from $100,000-$500,000, depending on the type of hedge fund and the manager’s strategy. Thus, hedge funds are mainly for “professional” investors, not retail investors.
Q. What is the difference between a hedge fund and a mutual fund?
A. The main difference between a hedge fund and a mutual fund is that hedge funds are privately offered investment vehicles for accredited investors only, whereas mutual funds are publicly offered to all types of investors. Hedge funds also use more aggressive strategies than mutual funds and typically have higher management fees.
Hedge funds also have a much wider mandate: they can short and trade many different asset classes.
Q. What are the risks associated with investing in a hedge fund?
A. The risks associated with investing in a hedge fund include liquidity risk, leverage risk, counterparty risk, and the risk of the fund manager’s strategy not working. Additionally, hedge funds are illiquid investments and may be subject to higher fees and performance restrictions.
Plenty of hedge funds enter the business every year, but many folds as well. The market is competitive.
Q. How often do hedge funds report their performance?
A. Hedge funds typically report their performance on a quarterly basis.
Q. Are there any tax implications associated with investing in a hedge fund?
A. Yes, there are tax implications associated with investing in a hedge fund. Investors should consult a tax advisor to understand what the implications may be.
Hedge fund strategies – conclusion
With the information provided in this article, (hopefully) you have gained some insights into how to run your own “one-man hedge fund”. Hedge fund strategies are no rocket science but it requires a lot of dedication, hard work, record-keeping, and trial end error.