What are the main types of hedge funds?

Key questions:

• What are hedge funds?
• What are long/ short equity funds?
• What are global macro hedge funds?
• What are trend-following/ CTA hedge funds?
• What are relative value hedge funds?
• What are activist hedge funds?
• How and why do people invest in hedge funds?

Hedge funds are a type of collective investment fund. They tend to differ from conventional equity or bond funds by the type of strategies they pursue, and the asset classes and instruments they invest in. As such, management of these funds is best performed by a specialist, with expertise in their area.

Hedge funds can be either a high-octane investment strategy, or a source of stable, uncorrelated returns for a portfolio or anything in between – depending on the approach used by the manager. The hedge fund sector, including funds referred to as ‘absolute return’, is diverse and multi-faceted and has the potential to fulfil a variety of roles in a portfolio.

While coming into focus at times of market volatility, there are styles of hedge funds to suit many different market conditions. These funds are designed to bring something different to a portfolio, providing a source of return away from the traditional equity or bond markets. They do this in a range of different ways. There really is no such thing as a typical hedge fund, but here we consider five of the main types: long/short, global macro, trend/CTA, relative value and activists.

In a traditional, or ‘long-only’, collective fund, a fund manager will invest in shares of companies that they believe will do well over time. As part of their research, they may also find companies that they think are more likely to do badly – perhaps the competitor of a top-performing company, or a supplier not meeting its obligations. However, most ‘long-only’ fund managers can only benefit from this information by choosing not to hold the shares.

Long/short equity funds aim to exploit both sides – going ‘long’, by buying shares in companies the managers think are likely to do well, and ‘short’, by selling shares in companies likely to do badly in their view. They go short by borrowing company shares and selling them. When they buy them back at a later date, they profit from any fall in the share price over that period.

This approach should work in most market conditions, though a lot will depend on the skill of the manager and the strength of their research. Shorting needs to be handled carefully, as the risks are much greater. Long positions can only go to zero, so investors can only lose what they invested. But selling something you don’t own exposes you to higher potential losses - a share price can grow to many times its original size and therefore so could corresponding losses on short positions. As such, the risk/reward of a short position is different and risk management controls are particularly important.

Long/short funds can have varying levels of exposure to the underlying markets in which they invest, typically equities and fixed income. Market-neutral funds have long and short positions equal to one another, so only profit according to the managers’ hypothesis on the individual stocks, rather than broader market movements. Other funds will have a ‘net-long’ position, where the portfolio will have positive exposure to the broad market and will therefore benefit from equity markets gaining ground. This position will vary from fund to fund, and the manager may also be able to vary exposure over time, so investors need to know the objectives of the fund and investment policy to understand the risks and performance characteristics.

Global macro funds are what many investors think of when it comes to hedge funds. The manager will take a view on significant economic or political events and use derivatives on equities, bonds, currencies and commodities to try to profit from that view. Global macro hedge fund managers may be taking positions on the likely direction of interest rates, the outcome of a significant event, such as the Brexit vote, or anything where they consider the market isn’t pricing an outcome correctly.

For each macro event, the manager will be looking to find the right combination of assets to profit when a specific outcome occurs. They can also trade volatility, profiting from general market disruption. Global macro funds should offer a differentiated return, lowly correlated to the return from bond and equity markets.

Global macro funds will vary significantly in the size of the positions they take. Some of them take lots of small incremental positions, aiming to minimise volatility for investors. Others will take large positions and may swing from significant profits one year, to significant losses the next. Potential investors should be examining a manager's long-term performance in detail with particular attention on the volatility of returns to see whether they are one or the other.

Trend strategies or commodity trading advisors (CTAs) are sometimes considered alongside the global macro fund universe. They share a low level of correlation to equity and bond markets over the long term. These funds seek to exploit trends and momentum in prices, typically using exchange traded futures contracts. They are diversified, looking for opportunities across all asset classes including equities, bonds, currencies and commodities, and can benefit from being long or short in any of them.

Relative value hedge funds will look to identify and exploit pricing anomalies between different securities sometimes within the same company. In the stock market, this can happen around a takeover or merger (merger arbitrage strategies), where two prices are expected to eventually trade at the same level, but there may be short-term differences as the details of the deal are worked out. Alternatively, it may be different parts of the bond market with different assumptions on interest rates or inflation. Skilled hedge fund managers can often exploit these differences for long-term gain.

Finally, there are a range of activist hedge funds, where a manager will take a significant stake in a particular company and then use their influence to bring about change. This may be breaking up a large conglomerate into its component parts to realise value, forcing a change of strategy from the management team or pushing for a sale or merger.

Many of the world’s largest hedge funds are difficult to access. They can have high minimum investment levels, high fees and are available by invitation only. However, many hedge fund strategies are available in an investment trust structure, trading on stock exchanges like company shares. The Targeted Absolute Return sector is also home to open-ended funds with a variety of long/short equity and bond strategies, plus global macro funds. These funds have strong regulatory parameters around them, with limits on borrowing and holding size.

Our view is that hedge funds can help diversify a portfolio, creating a ballast in difficult markets and providing a source of uncorrelated returns. However, there are a lot of funds pursuing very different strategies and investors must make sure they understand what they are buying. Careful analysis is vital in getting the right outcome for an individual portfolio.

Hedge funds can be complex products aimed at professional or experienced investors who are comfortable with taking a different risks and paying higher fees. Some hedge fund managers buy and sell a wide variety of financial securities and employ complex and sophisticated strategies. This means there can be additional financial risks which may not be present in other investments. Anyone considering them for a portfolio should make themselves aware of the specific risks and seek professional advice.