Hedge Fund Strategies

Hedge funds are defined less by what they own than by how they invest: with shorting, leverage, derivatives and few constraints. That freedom produces strategies with very different risks, from merger arbitrage that behaves like selling insurance to trend following that tends to profit when markets break. This module classifies the main strategies, explains how each is implemented and where it can fail, compares funds of funds with multi-strategy funds, and shows how a conditional factor model reveals the risks that only appear in crises and how adding a hedge fund changes a portfolio's risk and return.

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What you will learn

1. Classify hedge fund strategies into broad families and describe the characteristics that distinguish them.

Families: equity-related, event-driven, relative value, opportunistic, specialist and multi-manager.
Gross exposure (long + short) measures leverage; net exposure and net beta measure directional risk.
Strategies differ as discretionary or systematic, top-down or bottom-up, and by the liquidity of what they hold.
Arbitrage and event-driven strategies tend to show negative skew; trend following and some macro positive skew.
Classify funds by measured exposures, not by name or marketing.

2. Explain how equity-related and event-driven strategies are implemented and identify the risks they bear.

Long/short equity profits from stock selection plus a usually long net exposure; risks include crowding and short squeezes.
Dedicated short funds have negative beta and face potentially unlimited losses on shorts.
Equity market neutral uses leverage on small, often quantitative signals and is exposed to crowded unwinds.
Merger arbitrage earns the deal spread; its payoff resembles selling a put, with large losses if deals fail.
Distressed investing depends on legal outcomes and illiquid securities, requiring long lock-ups.

3. Explain relative value, opportunistic and specialist strategies, their risks and their roles in a portfolio.

Fixed-income arbitrage earns small convergence spreads with high leverage; liquidity crises and margin calls are the key risks.
Convertible arbitrage buys cheap convertibles, shorts delta shares and profits from gamma trading; credit, borrow and liquidity risks dominate.
Global macro is top-down and discretionary, often concentrated, with lumpy returns.
Managed futures (mostly trend following) show positive skew and tend to perform well in prolonged sell-offs.
Specialist strategies (volatility, reinsurance, life settlements) need niche expertise and can diversify financial-market risk.

4. Compare funds of funds and multi-strategy funds, including their fees, diversification, transparency and risks.

Funds of funds diversify across managers and offer selection and due diligence expertise, at the cost of a second fee layer.
FoFs do not net incentive fees across underlying managers, so investors can pay incentive fees in a flat year.
Multi-strategy funds reallocate capital quickly, have full transparency and central risk control, and often net performance across strategies.
Multi-strategy risks: single-firm operational concentration, hidden aggregate leverage and possible pass-through expenses.
Operational due diligence (custody, administration, valuation, audit) is essential for both structures.

5. Use a conditional factor model to analyse a hedge fund strategy's risk exposures and evaluate the effect of adding a hedge fund allocation to a traditional portfolio.

Hedge fund returns load on equity, credit, rate, currency, commodity and volatility factors.
A conditional model adds crisis-dummy interactions: crisis exposure = normal beta + crisis increment.
Many strategies' equity and credit exposures rise in crises; macro and managed futures often fall.
Portfolio risk depends on correlation: combine weights, volatilities and correlation, then compare Sharpe ratios.
Check Sortino ratios and maximum drawdowns too, since full-sample correlations can hide crisis behaviour.

Module at a glance

Strategy families: equity-related, event-driven, relative value, opportunistic, specialist and multi-manager.
Gross exposure measures leverage; net exposure and net beta measure directional risk; classify funds by measured exposures.
Merger arbitrage earns the deal spread with a short-put-like risk; dedicated shorts face squeezes and unlimited losses.
Relative value strategies earn small spreads with high leverage and suffer in flights to liquidity; managed futures are positively skewed.
Funds of funds add selection and diversification but layer fees without netting; multi-strategy funds net fees and reallocate quickly but concentrate operational risk.
Conditional factor models add crisis-dummy terms: crisis exposure = normal beta + crisis increment.
Judge an allocation by its effect on Sharpe ratio, Sortino ratio and drawdowns, not by stand-alone returns.

This free module has 5 lessons, 15 practice questions with full explanations.

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