Hedge Fund Strategies

Hedge funds form an important subset of the alternative investments opportunity set, but they come with many pros and cons in their use and application across different asset classes and investment approaches. The basic tradeoff is whether the added fees typically involved with hedge fund investing result in sufficient additional alpha and portfolio diversification benefits to justify the high fee levels. This is an ongoing industry debate.

Some argue that investing in hedge funds is a key way to access the very best investment talent—those individuals who can adroitly navigate investment opportunities across a potentially wider universe of markets. Others argue that hedge funds are important because the alpha that may be produced in down markets is hard to source elsewhere.

The arguments against hedge funds are also non-trivial. In addition to the high fee levels, the complex offering memorandum documentation needs to be understood by investors (i.e., the limited partners). Other issues include lack of full underlying investment transparency/attribution, higher cost allocations associated with the establishment and maintenance of the fund investment structures, and generally longer–lived investment commitment periods with limited redemption availability.

In addition, each hedge fund strategy area tends to introduce different types of added portfolio risks. For example, to achieve meaningful return objectives, arbitrage-oriented hedge fund strategies tend to utilize significant leverage that can be dangerous to limited partner investors, especially during periods of market stress. Long/short equity and event-driven strategies may have less beta exposure than simple, long-only beta allocations, but the higher hedge fund fees effectively result in a particularly expensive form of embedded beta. Such strategies as managed futures or global macro investing may introduce natural benefits of asset class and investment approach diversification, but they come with naturally higher volatility in the return profiles typically delivered. Extreme tail risk in portfolios may be managed with the inclusion of relative value volatility or long volatility strategies, but it comes at the cost of a return drag during more normal market periods. In other words, some hedge fund strategies may have higher portfolio diversification benefits, while others may simply be return enhancers rather than true portfolio diversifiers. Many hedge fund strategies employ leverage to amplify their asset base and to increase their returns, through the combination of margin, highly levered derivatives, and other highly leveraged investment strategies.

Also, the hedge fund industry continues to evolve in its overall structure. Over the past decade, traditional limited partnership formats have been supplemented by offerings of liquid alternatives (liquid alts)—which are mutual fund, closed-end fund, and ETF-type vehicles that invest in various hedge fund-like strategies. Liquid alts are meant to provide daily liquidity, transparency, and lower fees while opening hedge fund investing to a wider range of investors. However, empirical evidence shows that liquid alts significantly underperform similar strategy hedge funds, which suggests that traditional hedge funds may be benefiting from an illiquidity premium phenomenon that cannot be easily transported into a mutual fund format. Since these liquid alternatives are often subjected to meeting certain regulatory criteria, their inherent structures restrict the use of highly risky, illiquid investment strategies and alternatives.

Investors must understand the various subtleties involved with investing in hedge funds. Notably, as demonstrated by the endowment model of investing, placing hedge funds as a core allocation can increase net returns and reduce risk.

This learning module presents the investment characteristics and implementation for the major categories of hedge fund strategies. It also provides a framework for classifying and evaluating these strategies based on their risk profiles. Section 1 summarizes some distinctive regulatory and investment characteristics of hedge funds and discusses ways to classify hedge fund strategies. Sections 2 through 12 present investment characteristics and strategy implementation for each of the following hedge fund strategy categories: equity-related; event-driven; relative value; opportunistic; specialist; and multi-manager strategies. Section 13 introduces a conditional factor model as a unifying framework for understanding and analyzing the risk exposures of these strategies. Section 16 evaluates the contributions of each hedge fund strategy to the return and risk profile of a traditional portfolio of stocks and bonds.