Types of Hedge Funds

The market for hedge funds has grown significantly and there are many types of hedge funds around the globe. These hedge funds can be classified based on their size, global reach, and investment strategies among others. However, these classifications are not exclusive and there is some degree of overlap. Presented below is one type of classification of hedge funds:

Long/Short Funds

These are the most common form of hedge funds that take long and short bets in stocks. The long and short exposures will be based on forecasts. If the stock prices are expected to rise the fund will take  a long position, and if the prices are expected to fall, they will take short positions. The funds will make heavy use to leverage in their positions. The funds will generally not be market neutral and will maintain a positive or negative market exposure.

Market-neutral Funds

These are a type of long/short funds that take long and short positions so that their net exposure is zero. The total value of all long positions will equal the total value of all short positions.  Such a portfolio will be dollar neutral and beta neutral. These funds also use leverage. Market-neutral funds use various strategies such as long/short equity, fixed-income arbitrage, pairs trading, warrant arbitrage, mortgage arbitrage, convertible bond arbitrage, closed-end fund arbitrage, and statistical arbitrage, among others.

Note that even though we see terms such as arbitrage and market-neutral, these funds are not actually risk-free.

Global Macro Funds

These funds place directional bets on stocks, currency, interest rates, commodities, and macroeconomic variables. These funds are highly leveraged and use derivatives extensively. Within global macro funds there are specialized funds, such as futures funds, and emerging market funds.

Event-driven Funds

Event-driven funds place bets on events affecting companies or securities. For example, if a company is in financial difficulty and is undergoing restructuring, the fund may buy its securities at a deep discount (distressed securities), and stands to earn well if the company is successful. Another example is mergers and acquisition related events. When a company announces its merger or acquisition, its stock will sell at a discount before the effective date of the acquisition. The hedge fund may indulge in risk arbitrage by buying stocks of company being acquired and at the same time selling stocks of the acquiring company.