Hedge funds are investment funds which use aggressive strategies to seek a certain percentage of return, regardless of market conditions. They are pooled investment portfolios overseen by professionals, similar to mutual funds. However, hedge funds do not share the same restrictions as mutual funds and thus can take on more aggressive strategies. As a result, hedge funds are high-risk, high-reward options compared to mutual funds. There are three categories of strategies that hedge funds use: arbitrage, event-driven and tactical.
Function
The term hedge funds come from strategies where investors have a position in a company and hedge their bets in case their position is wrong. Hedge funds use long and short positions as well as options trading to try to gain absolute returns. Thus, hedge funds aim to receive a certain percentage of returns regardless of market conditions. As a result, hedge funds are very popular in bear (declining) markets.
Arbitrage Strategies
Arbitrage strategies, also known as relative-value strategies, are considered relatively risk-free strategies that involve buying in the money and selling for immediate profit. Buying in the money means that you are purchasing an option whose exercise price is less than the current market price for that security. Thus, if you ignore fees, you are essentially buying something for less than its true value and can make an immediate profit. Therefore, these strategies are seeking to exploit price inefficiencies. Arbitrage involves the use of derivative instruments, trading software and various trading exchanges--for example, trading on multiple exchanges and making money on the price differences between the exchanges. Although some of these differences may seem insignificant, when trading at high volume the results can be quite large.
Event-Driven Strategies
Event-driven strategies use one-time events such as merger announcements to take advantage of price fluctuations. For example, a hedge fund might buy the stock of a soon to be acquired firm and short sell the stock of the acquiring firm. There are several types of event-driven strategies, such as investing in a distressed security or buying a considerable portion of a small underachieving company. The results of this type of strategy are often not correlated with the performance of the market.
Tactical Strategies
Tactical strategies are probably the most common used by hedge funds. These strategies usually use long and short positions to hedge the risk of the direction the market is moving. A popular strategy is the macro strategy which seeks profits in global economies by betting on changes in interest rates, currencies and commodities brought upon by shifts in government policy. "Market neutral" is another tactical strategy which uses equally weighted short and long portfolios of one sector, thus reducing market risk. This strategy works well in a bear market, but must involve extensive security analysis in order to be successful.
Warning
Due to the high risk that comes with these strategies, many people have lost a lot of money investing in hedge funds. Although the reward is very appealing, the potential losses can be devastating. Moreover, individual investors usually run into liquidity problems when investing in hedge funds. When you invest with a hedge fund, there is usually a one-year lock on your money before you are allowed to withdraw any of it. Moreover, the fees greatly reduce any profit gained. However, it is a much better bet to invest with a hedge fund than trying to use these strategies on your own. Unless you're a professional, the likelihood of you losing all your invested money with these high-risk strategies is very high.
