Why Classify Hedge Funds into Styles?
Classifying hedge fund trading styles into groups is good for:
- Choosing the right funds to invest in. Some trading styles are entirely unsuitable for a particular investor’s risk and return objectives and by knowing the basic characteristics of hedge fund styles the investor can immediately eliminate a large number of unsuitable funds. Knowing hedge fund styles saves time and money.
- Measuring and comparing their performance. Comparing a fund’s performance to funds with totally different trading strategies makes little sense.
Mutual Funds Have Styles Too
Traditional mutual funds are also classified based on trading styles. On the broadest level we distinguish between equity (stock) funds and fixed income (bond) funds. Among equity funds there are value funds, growth funds, small cap funds, sector funds, emerging market funds etc. In short, there are various commonly known types of mutual funds based on their trading styles.
An investor quickly gets the first basic idea about a fund’s style of trading by looking at the fund’s name or at a few sentences at the beginning of the fund’s prospectus or promotional material. By knowing the fund’s style of trading, the investor already knows what to expect in terms of performance and risk exposures before digging deeper into the details of that particular fund.
Why It Is More Difficult to Classify Hedge Funds
Compared to mutual funds, classifying hedge funds into several style-based categories is more difficult because:
- Hedge fund trading strategies are much more diverse. While mutual funds are restricted by laws and regulations in their trading, there are virtually no limits to what a hedge fund can do and trade in the markets. There are thousands of different trading approaches. Due to the tough competition, a viable trading strategy requires a lot of details and nuances. Though hedge funds have become mainstream in the last years, it is still hard to find two funds trading exactly the same way.
- Hedge fund managers often keep their trading strategies secret to preserve their competitive advantage and the strategy’s profitability.
No Single Correct Hedge Fund Style Classification
With the growing popularity of hedge funds, the number of people researching them has also increased, and so has the number of approaches to classification of hedge fund trading styles.
Each of the major hedge fund index providers (like Credit Suisse Tremont, Hedge Fund Research, or EDHEC) has slightly different structure of the indices and uses different names and definitions for the style groups, though all of them cover the same universe of hedge funds.
Four Big Groups of Hedge Fund Strategies
In general, we can classify hedge fund strategies into four large groups:
- Equity market directional funds
- Relative value funds
- Corporate restructuring funds
- Macro trading funds
Equity Market Directional Funds
Equity market directional funds take long and/or short positions in individual stocks or ETFs. The long and short positions partly offset each other, therefore the overall equity market exposure can be limited (but usually it is not zero). Many managers analyze financial statements and fundamentals of companies in great detail, but there are also funds trading based on technical analysis or quantitative models. Common strategies include long/short equity, short selling, and market timing.
See more about equity market directional hedge funds.
Relative Value Funds
Relative value (or arbitrage) funds trade various spreads and bet on relative price differences of one security vs. a related security. Arbitrage funds typically use sophisticated computer models, as computers are faster in discovering a mispricing than human beings. The mispricing (the profit opportunity) is often very small and high leverage is used. Common strategies include fixed income arbitrage, volatility arbitrage, convertible arbitrage, and equity market neutral.
See more about relative value (also called convergence trading) hedge funds.
Corporate Restructuring Funds
Funds focusing on corporate restructuring trade securities (mostly stocks and bonds) issued by companies in special situations like distress, bankruptcy, or merger. The securities are often not publicly traded and there may be a closer relationship between the fund manager and the company. Sometimes the fund managers get even actively involved in the decision making inside the company during the restructuring. Common strategies include trading distressed securities, event driven strategies, and merger arbitrage.
Macro Trading Funds
Macro trading funds are funds taking directional positions in stock indices, currency exchange rates, interest rates, and commodities. Unlike equity market directional funds, macro funds focus on broad macroeconomic developments rather than on individual companies. Decision making tools range from studying macroeconomic fundamentals over simple technical analysis to quantitative models (sometimes it is a combination of these). Macro funds often use leverage. Typical trading vehicles are futures and options. Besides global macro funds, commodity trading advisors (CTAs) are often included in this group.
More Information about Hedge Fund Trading Styles
Websites of hedge fund index providers:
Good books about hedge fund trading styles: