This page explains the equity market directional hedge fund style, its unique characteristics, risks, substyles and common trading strategies.
Equity Directional Hedge Funds vs. Mutual Funds
Equity market directional funds represent the most common hedge fund strategy group. Mostly trading stocks, they are like classical stock mutual funds, but they typically have more freedom and more courage in their trading strategies.
Unlike classical mutual funds, equity market directional hedge funds often:
- take short positions as well as long,
- use derivatives (mostly options),
- have concentrated portfolios.
Investment Universe of Stock Hedge Funds
Equity market directional funds are a very diverse group. Some funds are focused on picking single stocks from all sectors, while others are sector specialists and only trade for example healthcare stocks or IT stocks. There are value funds, growth funds, large-cap, small-cap, and many other styles that don't even have names.
Some equity hedge funds bet on relative performance of one stock or sector vs. another and their strategies are more or less close to arbitrage funds.
Decision Making Tools
Regarding tools and decision making, many fund managers dig deep into corporate fundamentals. Not only they know every word and every figure in the annual reports and financial statements, but they often explore the whole value chain and competitors, and as a result their knowledge of the company's business is comparable to that of the management of the company itself.
There are other managers who are technicians and rely on charts, and other managers who build quantitative computer models. Many hedge funds combine all these approaches. Every method has a potential to work if done right, but at the same time every approach can fail. The stock market game is tough and the rules are changing constantly.
Substyles and Trading Strategies
- Long/Short Equity – the most common and almost all encompassing group. Long/Short funds take long and short positions in different stocks simultaneously, buying the stocks they like and shorting the stocks they believe will underperform. Though this approach limits the overall systematic stock market exposure, some exposure typically remains (this is what distinguishes the Long/Short group from market neutral arbitrage and pairs trading funds).
- Dedicated Short or Short Bias Funds – these are the bears who bet on companies to fail and on stock prices to decline. The typical characteristics of these funds is their net short equity market exposure. Extremely thorough fundamental research is usually done before taking a position.
- Market Timing Funds – these usually don't focus that much on single stocks, but try to take advantage of the moves of the stock market as a whole, either up or down. They trade stocks, options or futures. Market timers are at the border between equity market funds and global macro funds.
- Emerging Market Equity Funds – these hedge funds trade stocks from emerging markets like Asia, Eastern Europe, Latin America, or even Africa. They are often long-only, as short selling and derivatives are not that well developed on some emerging markets.
Risks of Equity Market Directional Hedge Funds
Because equity market directional funds are by definition non-neutral and have some market exposure, the main risk of investing in these funds is the systematic equity market risk. If you invest in a fund that is net long stocks and the stock market crashes, you are very likely to lose money. This works the other way too – short biased funds lose money when stock market grows.
Additionally, there is the risk that the fund's manager won't have enough skill (or luck) and his stock picking will prove weak. With equity hedge funds, which are typically far from indexing or passive strategies it sometimes happens that their stock picking is simply very wrong – you surely can lose money even when the market as a whole goes up.
Furthermore, you often see hedge funds with very concentrated portfolios. It is not unseen that one stock or one idea represents an exposure of more than 10 or 15 percent of the fund's equity. Then you are exposed to high specific risk of that one company or security.
Examples of Equity Market Directional Funds
A well known example of long-short hedge fund managers is David Einhorn, who openly criticized Lehman Brothers for hiding losses and exposures in their financial statements and communication, and made a lot of money on shorting the stock prior to Lehman's bankruptcy in 2008.
Few years back Einhorn had a similar bearish battle with Allied Capital. David Einhorn has written a book about his trading views and approach: Fooling Some of the People All of the Time: A Long Short Story. Though his Greenlight Capital is officially a long-short value fund, Einhorn became famous mainly thanks to his successful bearish trades.
Another name which comes to my mind here is the most famous investor in the world, Warren Buffett. His Berkshire Hathaway is technically not a hedge fund, but its trading approach, though long-only, is very close – thorough (and own) research of the fundamentals and very concentrated portfolio. After all, the borderline between equity hedge funds, private equity funds, and holding companies is getting more blurred in the recent years.