jeffnash's  Instablog

In a previous

post

, we pointed out that "hedge funds" are essentially an industry term for a category of investment funds that―due to having a small number of "sophisticated" or "accredited" investors―are not covered by the same rules that apply to larger, more publicly accessible mutual funds. Because of their lightly regulated status, hedge funds are allowed to use a wider variety of trading tools, making possible a larger number of investment strategies than are available with traditional mutual funds and other investment companies.

While not an absolute rule, individual hedge fund strategies tend to fall into three broad categories:

• Relative value arbitrages

◊ Market neutral
◊ Convertible arbitrage
◊ Capital structure arbitrage

• Event-driven

◊ Merger arbitrage
◊ Distressed situations

• Directional

◊ Traditional long strategies in hedge fund structure
◊ Short funds
◊ Long-short equity (combines directional and relative value approach)
◊ Managed futures (often called commodity trading advisors or CTAs)
◊ Global macro / Global tactical asset allocation

This categorization covers most single-strategy hedge funds. In addition, there are funds-of-hedge-funds, which aggregate investments among several hedge fund managers and try to add value either by diversifying manager risk or by arranging for the diversification among strategies.

Multi-strategy hedge funds are single funds that use a combination of the above strategies, either by trying to select the best-performing strategy for the current environment, or by allocating assets among internally managed programs in a way that best profits from the correlation among separate strategies. Multi-strategy funds can be similar to funds-of-hedge-funds except that the sub-fund allocations are all managed in-house. The multi-strategy hedge fund may have a more attractive net fee structure than a similar fund-of-funds, and this may make sense, at least to the extent that the investor trusts the manager to be adequately skilled in each of the multi-strategy fund's sub-strategies.

Finally, in an attempt to differentiate themselves, many hedge funds try to combine or mix these strategies. As a result, the boundaries between strategies are not always clear-cut in practice and can require substantial due diligence both before and during investing. In many cases, however, it is sufficient to understand the general approach of a combined strategy and simply decide whether it makes sense to mix them.

Relative value strategies look for securities that are mispriced relative to each other and make money by shorting the overpriced security while holding the underpriced one. The goal of relative value strategies is to capture the profit potential of securities that are mispriced relative to each other while neutralizing the effect of other market risks (equity market risk, fixed-income duration risk, etc.). These strategies require the use of leverage and margined securities to magnify return potentials and keep long and short securities balanced in the proper ratios.

Event-driven funds capture opportunities presented by corporate (or other organizational) events such as mergers, initial public offerings (IPOs), spin-offs, buyouts, legal cases, regulatory decisions, and bankruptcies. They typically use long exposures in one security combined with shorting others and/or derivatives to neutralize other sources of market risk. In their implementation, event-driven funds have some similarities to relative-value funds, but the key feature in these funds comes from the fund managers' ability to analyze the behavior of corporate, government, and/or regulatory actors.

Directional funds allow their portfolios to take on market risk and often deliberately incorporate views on overall market direction through either discretionary or systematic manager decisions. Systematic decisions are rule-based, whereas discretionary means that manager judgment and/or instinct is used.

A future post will give a brief overview of each individual hedge fund strategy.

Disclosures & Disclaimers
Securities offered through Registered Representatives of Centara Capital Securities, Inc., Member FINRA/SIPC, and Centara Insurance Services. CA Insurance Lic. #0F30702. Investment advisory and financial planning services offered through Centara Capital Management Group, Inc., a Registered Investment Advisor. CA Insurance Lic. #0D85861. Legal services provided by Centara Legal Group, APC, David J. Gebhardt, Principal. None of the information presented is to be construed as investment advice. See a prospectus before investing.

This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation.All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results.