Hedge Fund Trading Strategies (Backtests And Examples)

Last Updated on October 10, 2022 by Oddmund Groette

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 they?

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. So, they are meant for accredited investors and institutions.

In this post, we take a look at hedge funds and their strategies. 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.

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.
  5. 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.
  6. 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.
  7. 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.
  8. Its objective is.
  9. 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.
  10. 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.
  11. Quantitative Strategies: These make use of technology-based algorithmic modeling to achieve desired investment objectives. They rely on quantitative analysis to make investment decisions.
  12. Global Macro: 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.
  13. 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:

  1. 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.
  2. Defining the rules: Here, the edge is converted to a strategy by stating the criteria for trade entry and exits and other risk management parameters.
  3. 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.
  4. 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.
  5. Strategy deployment: If the strategy does well in the current market condition, it can be deployed to trade real money.
  6. 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.

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 Microsoft for $1,270, 000, which covers the Hyundai 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)

Coming soon.

Similar Posts