Similar to the joke about economists, though there are more than ten thousand hedge funds, there are eleven thousand hedge fund strategies. Well, not really, but for every hedge fund there is a different strategy or at least a different spin on a strategy. Otherwise, if they all did the same thing, how would they expect to outperform.
Risk Levels
Hedge funds are not homogenous. They take varying amounts of risk. Some may exhibit less risk than treasuries, while others may exhibit risk levels that are several times the most volatile of markets. It simply depends on the strategy that is being pursued and the amount of leverage that is being employed. Some say that the fund Long Term Capital Management was levered two hundred fifty to one. Now that is extreme and it nearly brought down the financial system back in 1998.
Hedging
Many, but not all, hedge funds hedge or attempt to reduce the risk in their underlying positions by shorting or through buying protection in the form of puts or other derivatives. The point of hedging is to reduce risk, while still generating market beating returns. However, hedges are often imperfect, which means that they don’t always zig when other investments zag. If they don’t track the inverse of the underlying closely enough, even a firm that is hedged can experience severe losses. Sometimes the losses will be so severe that they exceed what would have occurred if the firm was unhedged.
Types of Strategies
Global macro is the strategy that is the most well known. Early practitioners like Soros, Druckenmiller and Tudor Jones have made huge sums of money and equally huge wagers on global events and distortions caused by central banks. Soros and Druckenmiller are famous for betting against the Bank of England and winning, making more than $1 billion in a single day.
Market neutral strategies aim to generate absolute returns in excess of the risk free rate without fluctuations due to market risk. They do this by doing arbitrage or equity long/short where they buy a stock that is expected to go up and short a stock that is expected to fall. Buy neutralizing their market exposure they hope to avoid the fluctuations caused by the market while reaping the returns generated by good security selection.
Distressed securities strategies are ones that seek to buy the stocks or bond or other instruments of companies that are in deep trouble. Deep distress leads to equally distressed prices. Firms look to buy securities that still have value even in bankruptcy and hope to profit when the firm emerges from bankruptcy or is able to surmount the economic troubles that it faces. When they are right, they can make returns that are many times that of their initial investments.
Pure short selling strategies are rare because the stock market has historically gone up, so these strategies are akin to swimming upstream. But at the end of massive bull markets these strategies can be highly successful and the only strategies that generate positive returns when all other long based strategies are faltering.