Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Types of Hedge Fund Strategies

There are several broad categories of hedge fund strategies and styles that are useful to understand before delving into additional detail.

Hedge funds can attempt to profit from trading in a variety of instruments. Hedge funds typically trade either individual stocks, bonds, or options or instruments that allow them to take exposure to broad asset classes such as futures or sometimes ETFs. Hedge funds that invest in individual stocks may go either long or short, based on the results of their company-specific research and level of conviction in the ideas or trends supporting each position. A manager who buys IBM and profits from its increase in value can at the same time sell Microsoft short and profit from its fall in value. A manager using this strategy would be relatively insulated from a fall in the overall technology sector and would seek to profit from the relative performance of IBM versus Microsoft in both rising and falling markets. Figure 1.9 shows the changes in prices for IBM, Microsoft, and the NASDAQ Composite over a 12-month period.

Figure 1.9 Long and Short Equity Opportunities

Source: Yahoo! Finance.

Some equity-oriented funds may buy or sell stocks and trade options to profit or enhance their particular views on volatility or market direction while investing only a small portion of their capital to take large amounts of risk. Managers ...