Hedge funds are a very diversified lot, but you can roughly classify them into 10 classes. The following should give a short description of how funds in different strategy classes aim to deliver returns. Different classes can make use different events arising in the markets in the market, so their return and risk profiles vary a lot.

The strategy classes are presented starting from the least risky and advancing towards the riskiest one.

Enhanced Moneymarket: Enhanced moneymarket funds invest mostly into fixed income instruments with short maturity, but the portfolio manager can take stance in the equity markets observing set limits.

Fixed income arbitrage: In these funds, the portfolio manager speculates on the changes in yield curves. For example, the portfolio manager may believe that the yields of Treasury bonds with short maturities decline more than yields of longer Treasury bonds, in which case he or she buys the shorter instrument and sells the longer one. These hedge funds usually have investments in multiple markets at once.

Convertible arbitrage: These funds buy undervalued convertible bonds while selling short the stock of the same issuer. The value of the convertibles usually increases more than that of the stock when the volatility in the markets rises. Funds in this strategy usually offer a good hedge when in times of falling equity markets.

Long Short Credit: Long Short Credit Funds invest their assets in debt securities. Their portfolio consists both of bought (longed) debt and sold (shorted) instruments. So the value of the fund increases if the bought debt appreciates more than the sold debt. In essence, the strategy is very similar to Long Short Equity, bar the instruments into which investments are made.

Event Driven: Event Driven funds are basically on the look for companies that are undergoing different kinds of events that may have an effect on their valuation. The most straightforward Event Driven fund invests in merger and acquisition cases, either when a bid for a company is announced or when one is expected. The latter case is riskier, because in some cases there might not be a bid. In the former case the price of the stock target of a bid usually stays below the bid because of the uncertainties involved. The portfolio managers analyze the probability of the deal actually happening and, if they deem it probable, they buy the shares of the target company. In the same time, they short the stock of the acquiring company to hedge against market risk.

Long Short Equity: These funds invest mostly into equities and equity derivatives such as options. While buying stock in companies they consider to have potential for appreciation, they hedge these investments with shorted stocks in companies they believe will depreciate or appreciate less than the longed companies. Some of the Long Short Equity funds have fully hedged their portfolio, so only stockpicking affects their performance. However, funds that have varying level of hedging are more common. These funds thus reflect the market fluctuations in their performance in the short term.

Macro and tactical trading: Macro funds invest globally in e.g. fixed income, equity and commodity markets. Unlike CTAs and Currency funds, the investment decisions are made by the portfolio manager and not by the computer model. Investment strategy is largely based on fast-paced buying and selling but the funds may hold investments with a longer time horizon. Tactical Trading funds are related to Macros but their investments are very short in horizon, usually a matter of hours.

CTAs and Currency managers (Systematic traders): These strategies are based on programmed computer models, which give indication to which instruments the fund should invest in and how big will the allocation be. Investments can also be short sellings. Currency managers usually invest only in to the most liquid variety of currencies (such as USD, the Euro and Yen), but CTAs (Commodity Trading Advisors, no connection to what they do whatsoever) have a wider mandate. In addition to currencies, they may also trade in equities, commodities and interest rate derivatives. This class is a very risky one, but in general they have been able to deliver quite high returns when the markets show a prominent rising or declining trend. When the trends turn, the losses can temporarily be quite considerable.

Printed from www.3cfund.com at 07.09.2010.