This guide aims to provide high-level information on various hedge fund strategies to help inform investors of the complex world of hedge fund investing. By employing the right strategy and hiring an experienced manager, investors can potentially achieve attractive returns while minimizing risk. We discuss equity long/short, credit, event-driven, multi-strategy, global macro, and equity market neutral hedge funds, including their potential returns and risks. While these funds can provide diversification benefits and potentially higher returns, they can also be complex and require a high degree of skill and expertise to execute successfully. Therefore, it is important to work with an experienced advisor and manager with a proven track record.
Equity Long/Short Hedge Funds
Equity long/short hedge funds employ a strategy that involves buying long positions in stocks that the manager believes will increase in value, while simultaneously selling short positions in stocks that they believe will decrease in value. By doing so, the manager can potentially generate returns while minimizing market risk.
One of the key risks associated with equity long/short hedge funds is that they are still exposed to market risk, as they typically have a net long exposure to the overall stock market.
Equity Long/Short Hedge Funds can be attractive in a variety of market conditions, including when there is a high level of stock price volatility, uncertainty, or mispricing.
According to data from Hedge Fund Research (HFR), the average annualized return for equity long/short hedge funds was 9.6% from 2011 to 2020, with a standard deviation of 7.1%.
Credit Hedge Funds
Credit hedge funds invest in a variety of credit instruments, such as bonds, loans, and other debt securities, with the goal of generating returns through interest income and capital appreciation. These funds may also employ strategies such as credit default swaps, distressed debt, and convertible arbitrage.
One of the key risks associated with credit hedge funds is credit risk, as these funds are exposed to the risk of default or downgrade of the underlying credit instruments. Additionally, these funds may have liquidity risk, as some credit instruments may be illiquid and difficult to sell.
Credit hedge funds can be attractive when interest rates are low or declining, as they can potentially generate higher returns by investing in credit instruments with higher yields.
According to data from HFR, the average annualized return for credit hedge funds was 6.7% from 2011 to 2020, with a standard deviation of 3.9%.
Event-Driven Hedge Funds
Event-driven hedge funds invest in companies that are undergoing significant corporate events, such as mergers, acquisitions, spin-offs, or bankruptcies, in an attempt to generate returns. These funds may employ strategies such as merger arbitrage, distressed debt, and special situations.
One of the key risks associated with event-driven hedge funds is event risk, as the outcome of corporate events may be uncertain and unpredictable. Additionally, these funds may have concentrated positions in specific companies or industries, which may increase their risk.
Event-Driven Hedge Funds can be attractive in periods of market dislocation or corporate events, such as mergers, acquisitions, bankruptcies, and spin-offs. These events often create opportunities for hedge funds to take advantage of pricing inefficiencies or mispricing in the market.
According to data from HFR, the average annualized return for event-driven hedge funds was 8.7% from 2011 to 2020, with a standard deviation of 5.5%.
Multi-Strategy Hedge Funds
Multi-strategy hedge funds are characterized by their ability to invest across a range of strategies, including equity long/short, credit, and event-driven. This flexibility allows managers to allocate capital to the most attractive opportunities across markets and asset classes, which can potentially lead to attractive returns.
One key risk associated with multi-strategy hedge funds is that the performance of the different strategies employed by the fund may not always be correlated. This means that while some strategies may be performing well, others may be experiencing losses, resulting in an overall lower return for the fund. Additionally, if the fund relies heavily on a particular strategy, a significant loss in that strategy could have a significant impact on the overall performance of the fund. As a result, investors in multi-strategy hedge funds need to carefully evaluate the fund's diversification and risk management strategies before investing.
Conversely, they are often attractive to investors for the same reason - the diversification across various hedge fund strategies, which can potentially result in smoother returns and lower volatility compared to single-strategy funds. However, managing multiple strategies can be complex, and it is important that the manager has the expertise and resources to effectively implement each strategy.
The average net return for multi-strategy hedge funds over the past 10 years has been 7.4% annually, with a range of 5.6% to 9.3% depending on the fund size and vintage year, according to a report by Preqin. According to HFR data from 2000 to 2019, Multi-Strategy Hedge Funds have an average annualized return of 5.27%, with a standard deviation of 6.23%.
Global Macro Hedge Funds
Global macro hedge funds aim to generate returns by investing in macroeconomic trends and events, such as interest rate movements, currency fluctuations, and geopolitical events. These funds typically take large directional bets on the direction of the markets and can be highly leveraged, which can lead to potentially attractive returns but also increased risk.
One key risk associated with global macro hedge funds is the risk of geopolitical events and macroeconomic changes. Since global macro hedge funds invest in various asset classes across different geographic regions, they are vulnerable to sudden changes in government policies, economic conditions, and global events such as wars, natural disasters, and political upheavals. These events can lead to significant market volatility, which can impact returns.
Global macro hedge funds can be particularly attractive in times of market volatility and uncertainty, as their flexibility and ability to take large directional bets can potentially lead to outsized returns.
The average net return for global macro hedge funds over the past 10 years has been 4.8% annually, with a range of 2.9% to 6.8% depending on the fund size and vintage year, according to Preqin. According HFR data from 1990 to 2020, the average annualized return for global macro hedge funds was 6.7%, with a standard deviation of 8.2%.
Equity Market Neutral Hedge Funds
Equity market neutral hedge funds aim to generate returns by investing in long and short positions in the equity markets, while attempting to maintain a market-neutral position. This means that the fund is not taking a directional bet on the direction of the markets, but rather seeking to profit from the relative performance of individual stocks.
One key risk associated with equity market neutral hedge funds is the potential for sudden changes in market conditions or unexpected events that can disrupt the balance between long and short positions, leading to significant losses. Additionally, these types of funds may rely heavily on leverage, which can amplify both gains and losses, increasing the risk of large drawdowns.
Equity Market Neutral Hedge Funds can be particularly attractive during periods of high market volatility, as their neutral positioning can potentially provide a hedge against broader market movements. Additionally, these funds can be appealing to investors looking for more consistent returns, as the focus on relative performance can potentially provide more stable returns compared to traditional long-only equity strategies.
The average net return for equity market neutral hedge funds over the past 10 years has been 4.4% annually, with a range of 3.3% to 5.3% depending on the fund size and vintage year, according to Preqin. According to HFR data from 1990 to 2020, the average annualized return for Equity Market Neutral hedge funds was 4.9%, with a standard deviation of 4.7%.
Relative Value Arbitrage Hedge Funds
Relative value arbitrage hedge funds aim to generate returns by taking advantage of pricing discrepancies in the markets. This can include investing in pairs of stocks or bonds that are considered to be mispriced relative to each other or taking advantage of pricing discrepancies between different markets or asset classes.
One key risk associated with these strategies is the risk of a sudden change in market conditions. This type of hedge fund relies heavily on identifying pricing discrepancies in the market and taking advantage of them. However, if market conditions change suddenly, these pricing discrepancies may disappear, and the fund may not be able to generate the expected returns. Additionally, the fund may be exposed to risks related to interest rate changes, credit quality, and other factors that can impact the pricing of securities. The success of a relative value arbitrage hedge fund is highly dependent on the skill of the portfolio manager in identifying and managing these risks.
Relative Value Arbitrage Hedge Funds can be particularly attractive in times of market volatility and uncertainty, since these funds aim to generate returns that are largely independent of overall market movements.
The average net return for relative value arbitrage hedge funds over the past 10 years has been 6.1% annually, with a range of 4.5% to 7.5% depending on the fund size and vintage year, according to Preqin. According to Hedge Fund Research (HFR) data from 1990 to 2020, the average annualized return for Relative Value Arbitrage hedge funds was 6.5%, with a standard deviation of 5.6%.
Unlocking Investment Success: Why Working with a Best-in-Class Manager is a Must
While hedge funds can potentially provide attractive returns, they can also be complex and risky investments. Therefore, it is important to work with an experienced manager with a proven track record of successfully navigating these types of investments.
Studies have shown that working with a top-quartile hedge fund manager can make a significant difference in investment performance compared to a bottom-quartile manager. According to data from eVestment, over the five-year period from 2016 to 2020, the average annual return for top-quartile hedge funds was 14.5%, while the average annual return for bottom-quartile hedge funds was just 1.3%. In addition, top-quartile hedge funds had a lower average standard deviation (8.7%) compared to bottom-quartile hedge funds (13.8%).
When evaluating potential managers, it is important to consider their track record of success, their investment process, their risk management practices, and their level of transparency and communication with investors. The IIM Alternatives Platform has been designed to facilitate these activities for its clients.
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The CCP investment team conducts an initial screen to identify institutional private fund managers that have displayed their ability in navigating multiple market cycles, have proven track records, enhanced risk management frameworks, and deep teams. The investment committee, which has been intact for over 25 years, then reviews the recommendations on an ongoing basis.
IIM provides a final layer of client specific analysis, delivering a custom recommendation based on current holdings and unique objectives. The result is a sophisticated and highly customized investment solution comprised of top institutional investment managers.
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References:
Preqin (2021). 2021 Preqin Global Hedge Fund Report.
Hedge Fund Research (HFR). (2021). Hedge Fund Research Data: Hedge Fund Indices (https://www.hedgefundresearch.com/family-indices)
"The Performance and Persistence of Multi-Strategy Hedge Funds: Evidence from a Large Dataset" by Diogo Palhares, Yingjie Qi, and Yao Chen (2021).
CEM Benchmarking (2017). Does Manager Selection Matter?
eVestment (2021). "Hedge Fund Performance Report: 2020 in Review." (https://www.evestment.com/resources/research-reports/hedge-fund-performance-report-2020-in-review/)
Forbes (2019). "The Importance Of Selecting A Top-Performing Hedge Fund Manager." (https://www.forbes.com/sites/greatspeculations/2019/03/20/the-importance-of-selecting-a-top-performing-hedge-fund-manager/?sh=42381c5635c6)
Bloomberg (2020). "Hedge Funds That Fared the Best (And Worst) in a Turbulent 2020." ( https://www.bloomberg.com/news/articles/2020-12-30/hedge-funds-that-fared-the-best-and-worst-in-a-turbulent-2020)
Institutional Investor (2018). "Why It's Important to Invest with Top Hedge Fund Managers." (https://www.institutionalinvestor.com/article/b17v6xhxgmf0w1/why-its-important-to-invest-with-top-hedge-fund-managers)