Types of Hedge Funds – What are they & How they work?
Hedge funds are a type of investment that entails the use of pooled funds that apply a variety of methods to allow investors to achieve active returns. It uses funds raised from authorised investors like banks, insurance companies, high-net-worth individuals and families, as well as endowments and pension funds. These funds are then invested in a variety of financial assets, and they frequently serve as offshore investment activities or private equity partnerships.
The technique employs leverage and derivatives to generate massive profits while avoiding risk by hedging, or diversification across several financial instruments. The purpose of this post is to raise awareness about this form of investing and to know the fundamentals of the various types of hedge funds.
We’ll go over the most important of the numerous sorts of hedge funds in this article. Though the radar covers a wide range of topics in a broad sense, it will be presented in a straightforward and simple manner here to understand the basics.
List of Hedge Funds:
The following is the list of hedge funds but we will study the first three in detail as they are the most important.
- Long-Short Funds: In this type of fund, the fund manager employs both short and long position tactics. Purchasing less expensive assets in order to sell them at greater rates is an example of this.
- Market Neutral Hedge Funds: Market neutral hedge funds seek to profit regardless of market conditions.
- Event-driven Funds: These funds profit by taking advantage of market-moving events. Political changes, impacting the price of stocks, and other similar events fall within this category.
- Fixed Income Arbitrage Funds: Here earnings are based on the price differentials offered to assets in different markets. However, it largely focuses on the fixed-income sector.
- Emerging Market Funds: These funds make money by investing in the securities of developing countries.
- Long-only Funds: These funds make money by anticipating future stock price increases and establishing long positions in stocks.
- Distressed Securities Funds: These are funds that buy a company’s major securities at steep discounts. The investor should be aware that if the company goes bankrupt, the securities in this fund will become worthless.
- Merger Arbitrage Funds: These funds earn money by selling and buying firm equities that are undergoing mergers and acquisitions.
- Macro Funds: These funds invest in a variety of securities, the prices of which are subject to fluctuation due to economic conditions.
1 – Long-Short Funds
Many hedge funds work in a similar fashion to mutual funds, holding positions in markets such as stocks or bonds, but hedge funds have the ability to go long or short on their assets, allowing them to take advantage of market trends.
Hedge funds, on the other hand, are not limited to trading long and short in stocks and bonds; they can trade nearly any financial instrument, making them more flexible than mutual funds.
When we’re in a bull market, for example, being long pays off, but not when we’re in a bad market. However, if one can go short in a bear market, this can be highly profitable.
And, although most investors are losing money, if you are short at these periods, you can be one of the persons taking it from them.
Of course, determining which type of market we’re in is the trick, but this isn’t all that tough, especially with the medium-term timeframes that most funds look at. Of course, determining this after the fact is much easier, but it’s not that difficult to see what way the market is headed in general, and while nothing moves straight up or down, there are definite trends that emerge.
This type of hedge fund is the most successful, and while there is some risk involved, it is significantly less risky than taking the long side and exposing oneself to the whole risk of the market. Individuals risk making too many mistakes if they do so without the necessary competence, while hedge funds hire people with true talent who are significantly less likely to make these errors.
Long-short strategies can be easily benchmarked against indexes and pure long funds, When we compare the two, we observe that long-short hedge funds outperform long-only funds in terms of returns and risk management, which should come as no surprise given the strategic advantages that long-short funds have.
2 – Market Neutral Hedge Funds
Market neutral funds also use a range of other complex tactics and strategies to achieve their objectives, Some of these will entail actual trading, such as holding long and short positions in derivatives to take advantage of any trading edge that may exist.
Arbitrage is at least a portion of this strategy, and arbitrage is as market-neutral as you can get because the trend is irrelevant. It doesn’t matter if something is moving up or down because you’re only interested in trading price discrepancies.
Arbitrage is out of reach for most ordinary investors since it necessitates a large quantity of capital and leverage, as well as cutting-edge quantitative analysis. Arbitrage is a strategy for profiting from price disparities between similar or identical assets, with the arbitrageur trading these little differences.
Arbitrage, in general, serves a critical role in markets. If you wish to trade options, for example, you want the price of the options to match the price of the asset. If you don’t, you won’t be able to receive the right kind of price that you are looking for.
3 – Event-driven Funds
Long-short hedge funds concentrate on the technical features of markets, hoping to profit from trends, whereas the event-driven hedge funds adopt a more fundamental approach, but not the same as investors. This is one of the best hedge funds considered today.
Trading distressed companies or corporations participating in takeovers, restructuring, mergers, and the like are the fundamentals that event-driven funds attempt to profit from
While arbitrage addresses price inefficiencies from a technical angle, event-driven funds seek to arbitrage fundamental inefficiencies, where the price of an asset may not be in line with what it should or may be worth when the dust settles.
When a company, for example, has been thoroughly beaten up but still has enough promise, an event-driven hedge fund may jump in and buy a significant piece of it, ostensibly rescuing it, but the goal is to profit from the projected reversal, not to save it.
Needless to say, this is not a low-risk approach, but the rewards can be enormous if you get these moves right. To pull this off, you’ll need world-class analysis, which these event-driven hedge funds have in spades and are looking to capitalise on.
One can invest in a certain type of hedge fund or seek maximum diversification by investing in hedge funds of funds, which spread things out and are similar to the S& P 500, which is an index of large-cap equities
This approach is particularly appealing to many individual investors who have little knowledge of the inner workings of some or all of these funds, and may not understand them well enough to want to choose one type over another, and can make this decision simple by simply selecting one type over another.