Hedge Fund Strategies
One reason hedge funds are restricted to sophisticated investors is the aggressive strategies they employ. Unlike mutual funds, hedge funds face few restrictions on how they invest; they can use leverage, short sell, and concentrate positions in ways that amplify both gains and losses.
Common Hedge Fund Strategies
| Strategy | Description | Risk Level |
|---|---|---|
| Short selling | Profiting from declining prices by borrowing and selling securities, then buying them back cheaper | High |
| Leverage | Borrowing money to amplify returns (and losses) | Very high |
| Derivatives | Using options, futures, and swaps to hedge or speculate | Varies |
| Concentrated positions | Investing heavily in a single sector, security, or position | High |
| Global macro | Making large bets on economic trends across countries (currencies, interest rates, commodities) | High |
| Long/short equity | Simultaneously holding long positions (expecting price increases) and short positions (expecting declines) | Moderate-High |
How These Differ from Mutual Funds
The contrast is important for the exam:
| Capability | Mutual Funds | Hedge Funds |
|---|---|---|
| Short selling | Limited (some funds) | Unrestricted |
| Leverage | Restricted by regulation | No regulatory limits |
| Derivatives | Limited use | Extensive use |
| Concentration | Diversification rules apply | Can concentrate heavily |
| Illiquid assets | Limited (liquidity requirements) | Can invest heavily in illiquid assets |
Strategy Details
Short selling:
- Borrow shares -> sell them -> buy back later at a lower price -> return shares -> keep the difference
- Risk: if the price rises instead of falling, losses are theoretically unlimited
Leverage:
- Borrow money to invest more than the fund's actual capital
- Amplifies gains: a 10% return on 2x leverage = 20% return on invested capital
- Also amplifies losses: a 10% loss on 2x leverage = 20% loss on invested capital
Long/short equity:
- Take long positions in undervalued stocks and short positions in overvalued stocks
- Designed to profit in both rising and falling markets
- The "hedge" in hedge fund originally referred to this hedging strategy
Exam Tip: Gotchas
The name "hedge fund" is misleading. While the original hedge fund strategy (long/short equity) was designed to reduce risk through hedging, many modern hedge funds use aggressive, speculative strategies that increase risk. Don't assume "hedge" means "safe" or "conservative."
Finally, let's examine the specific risks hedge fund investors face.