Hedge funds are one of the investments of choice for the super-wealthy.  One reason for this is that hedge funds can make money even when ordinary investments are in the doldrums.

How can you use the trading approaches that have made hedge funds successful in your own trading?  This article introduces the trading strategies used by hedge funds, and outlines how hedge fund performance is measured.  The next article in this series will help you to determine which strategies will give you the best chance of success in your own trading.

What is a Hedge Fund?

A hedge fund is an investment fund that measures its performance, not against an index, such as the DJIA, but against an absolute return e.g. provides a long term return of 10% with month to month volatility of less than 1%.

Typically the hedge fund managers earn a percentage of the return, as well as an upfront fee, and they usually have their own money in the fund.

A hedge fund can trade futures, forex, derivatives, stocks, in fact almost anything, and routinely takes both long and short positions.

The original meaning of a hedge fund was a fund that “hedged” risk by adopting a market neutral approach.  This was achieved by taking simultaneous long and short positions in different stocks.  Now hedge funds may not necessarily trade from a hedge position, and the above characteristics better identify hedge funds.

Hedge Fund Trading Strategies

The overall strategies used by hedge funds fall into five basic categories:

• Relative value – arbitrage transactions that aim to profit from the spread between two securities rather than from taking a market position.
• Event driven – aims to profit from corporate events such as takeovers, mergers, restructuring, liquidation and spin-offs.
• Directional / trading – seeks to identify and trade off major market trends rather than focusing on a single security.  This type includes macro strategies and managed futures.
• Long / short equity – takes a long position on undervalued stock and takes a short position on undervalued stock.  This is a very popular hedge fund strategy.
• Other – includes pairs trading, volatility trading and other strategies.

Strategies fall in and out of favour as returns change over time.  In the early 1990s, macro hedge funds comprised 71% of the market (this included funds like the George Soros Quantum Fund).  Large losses in 1994 and 1998 lead to about 50% of funds being relative value type funds, and long short equity funds being about 36% of the industry.

Measuring Hedge Fund Performance

Essentially you can measure the performance of any investment, including hedge fund strategies in two areas – average annual return, and volatility.  The optimal investment is one with a high average return and low volatility (variability of return).

The next article in this series will outline the returns from each strategy, and identify those that are practical for a small trader to use.

In the meantime, I have used the following book as a reference source for this article: Investment Strategies of Hedge Funds

Tags: global macro, hedge fund, long/short, pairs trading, trading strategy

This entry was posted on Sunday, June 22nd, 2008 at 3:19 am and is filed under Trading Systems. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.