Types of Hedge Funds: The Complete Guide

Types of Hedge Funds: The Complete Guide. Hedge funds are alternative investments that employ various strategies to generate returns, often using leverage and derivatives as risk management tools. There are many types of hedge funds, each with its philosophies, risk profiles, and fee structures. This guide provides an in-depth overview of the major categories of hedge funds and what makes them unique.

Key Takeaways

• Hedge funds actively exploit opportunities using leverage and derivatives
• Major categories include equity long/short, event-driven, relative value, and global macro
• Risks include high fees, low regulation, and liquidity issues
• Select based on track record, risk profile alignment, and fee structure
• Alternatives provide access to similar strategies for regular investors

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What are Hedge Funds and How Do They Work?

A hedge fund is an alternative investment vehicle that is more loosely regulated than traditional mutual funds. Hedge funds aim to make money in all market environments utilizing leverage, short-selling techniques, arbitrage strategies, derivatives trading, etc.

Some key points about hedge funds:

• Privately organized investment funds for institutions and wealthy individuals
• Employ absolute return strategies aiming for positive returns regardless of market conditions
• Actively managed using a wide range of investing techniques like short selling and leverage
• Fees include a management fee (1-2%) and a performance fee (15-25% of profits)

Hedge funds make money by exploiting market opportunities through active investing rather than just tracking indexes. The flexibility in strategies, tools, and lack of regulation give them the potential for higher returns but also increase risk.

Different Strategies Used by Hedge Fund Managers

There are many investing style categories that hedge funds are grouped into based on their primary strategies:

Long/Short Equity Funds – Take both long and short stock positions, aiming to reduce market exposure while profiting from stock gains and declines

Event-Driven Funds – Attempt to make money from events like mergers, bankruptcies, acquisitions and other special situations

Macro Funds – Analyze macroeconomic trends globally and take long and short positions across many asset classes

Relative Value Arbitrage Funds – Identify and profit from price differences between securities

Distressed Securities Funds – Invest in riskier securities priced below their actual value due to distress

Funds of Hedge Funds – Hedge funds that invest in other hedge funds instead of individual holdings

Each strategy has pros and cons in terms of risks, volatility, and opportunities for diversification.

Examples of Common Hedge Fund Types

There are thousands of hedge funds implementing all sorts of investment strategies. Here are explanations of some of the most common hedge fund types investors may come across:

Equity Market Neutral Hedge Funds

• Definition: Funds that invest both long and short in equal measure in the stocks of companies within the same sectors
• The goal is for longs and shorts to neutralize the overall market risk
• Benefits: Lower volatility and reduced correlation to equity markets
• Risks: Requires skillful stock picking to generate alpha

Fixed Income Arbitrage Hedge Funds

• Aim to profit from price anomalies between related fixed-income securities
• Leverage spreads between instruments with mismatched prices or maturities
• Complex strategies requiring specialized expertise

Global Macro Hedge Funds

• Take positions based on evaluations of macroeconomic trends like currency values, interest rates, etc.
• Top-down global perspective
• Tools Used: Stocks, bonds, futures, options, currencies
• Benefits: Diversification and lower volatility potential

Managed Futures Funds

• Invest in futures, forwards, and options in currencies, stocks, bonds, commodities
• Profits from long and short positions as market trends shift
• Benefits from low correlation to other assets
• Complex taxes and regulations involved

Also see: A Deep Dive into the World of Hedge Funds: Everything You Need to Know

The Risks of Investing in Hedge Funds

While hedge funds have the potential for impressive gains, they also come with substantial risks to consider including:

• Lack of regulation – Higher risk approaches may be used that are off-limits to retail funds
• High fees – Typical 2 and 20 fee structure means high costs that eat into profits
• Low transparency – Investors have limited insight into specific holdings and methods
• Illiquidity concerns – Lockup periods restrict investors from accessing capital

Proper due diligence is vital to avoid exposure to unnecessary risks and match the hedge fund strategy to appropriate investor objectives and constraints.

Hedge Fund Fees and How Managers Get Paid

Hedge funds have a unique fee structure commonly referred to as “Two and Twenty” made up of:

• Management Fee – Typically 2% of assets per year to cover operating expenses
• Performance Fee – Usually 20% of profits above a hurdle rate or high water mark

Performance fees offer an incentive alignment between investors and managers but can also motivate excessive risk-taking. Other fee considerations include lock-up periods, redemption policies, whether hurdle rates or high water marks are used, and whether there are soft dollar commissions or early withdrawal penalties.

How to Evaluate and Select Hedge Funds

Choosing a hedge fund involves rigorous evaluation of factors like:

• Track Record – Long-term consistent returns relevant to the strategy used
• Target Returns – Objective benchmarks for defining success
• Risk Profile – Volatility, drawdowns, leverage, and risk management procedures
• Manager Background – Experience, capabilities, and infrastructure of the team
• Fee Structure – Typical 2 & 20 but watch for additions, limitations, or waivers

The best hedge fund picks match manager strengths to specific strategies and align risk exposures to investor goals.

Hedge Fund Alternatives for Regular Investors

While most hedge funds are only available to accredited investors, there are some alternatives suitable for regular investors including:

• Mutual Funds Implementing Hedge Fund Strategies – Provide similar exposures but are regulated, fully liquid, and lower cost
• Funds of Hedge Funds – Pool investor capital into a fund that invests across hedge funds
• Collective Investment Trusts – Regulated funds that serve qualified retirement plans and participants

Carefully research hedge fund alternatives to understand exposures and risks before investing in retirement savings.

Frequently Asked Questions About Types of Hedge Funds

How many types of hedge funds are there?

There are thousands of different hedge funds globally pursuing countless strategies. About 12,000 hedge funds are currently reported on by HFR, a data provider that tracks industry metrics. No exact count exists for how many types there are since funds continuously innovate new approaches.

What is the most common type of hedge fund?

Equity long/short hedge funds make up the largest portion of assets under management globally, accounting for about 40% of capital invested in hedge funds. Multi-strategy and event-driven hedge funds are the next most common.

What are examples of hedge funds?

Some of the largest and most well-known hedge funds globally include Ray Dalio’s Bridgewater Associates (pure alpha strategy), James Simons’ Renaissance Technologies (quantitative), and Ken Griffin’s Citadel (multi-strategy).

Which of the following are common hedge fund types?

All of these hedge fund strategies are considered common categories: global macro, relative value, event-driven, equity long/short, managed futures, and multi-strat.

What category is a hedge fund?

Hedge funds are considered alternative investments, meaning they fall outside the traditional asset classes of stocks, bonds, and cash. They have the flexibility to utilize short-selling, derivatives, leverage, and complex strategies.

What are the best hedge funds?

The “best” hedge funds are highly subjective based on specific investor goals, time horizons, and risk tolerance. Top performers can be identified through rating agencies by returns, assets under management, or longevity.

Conclusion and Key Takeaways

Hedge funds aim to generate absolute returns in all market environments using leveraged, short-selling techniques and unconventional assets. While returns can be impressive, risks are also higher. The most suitable hedge funds match manager skill sets to strategies and align risk attributes with investor objectives.

With hundreds of hedge fund strategies available, focus on identifying well-managed funds matching desired risk exposures rather than chasing past returns alone.