Hedge funds explained: what are the different types?

What are hedge funds?

A hedge fund, like a conventional investment fund, is formed when investors, including individuals and institutions, pool their money together to invest in a range of assets such as equities, bonds and commodities, to make a return. However, they can adopt more aggressive, active, investment strategies including short-selling shares so they are not suitable for everyone.

The aim is not just to generate returns but to do so whatever the state of the stock market, in good times and bad. In fact, this is where the ‘hedge’ name comes in – a broad range of strategies are used to ‘hedge your bets’ and protect against losses. Nobody wants their portfolios pruned unnecessarily.

Because of the different strategies involved, they tend to be managed by specialist hedge fund managers.

Those accessible to UK investors are regulated – in the UK by the UCITS regulations or possibly the Alternative Investment Fund Managers Directive – and fund managers must be transparent about their dealings.

But, despite this, the sector has suffered some reputational damage in recent years with scandals including the Bernie Madoff ‘Ponzi scheme’ – a form of fraud – and insider trading at SAC Capital and The Galleon Group.

But overall, the global hedge fund sector remains healthy with around $5 trillion of assets under management with the largest share managed in the US.

We believe that the hedge fund sector, including funds referred to as absolute return funds, can help improve portfolio diversity and performance in many different market conditions for investors who understand the risks and fees involved.

Understanding the various types of hedge funds is a good place to start:

What are five main types of hedge funds?

1. Long/short equity funds

A long equity investment approach is one which should be easily understood by all investors. It's where a fund manager, or a self-invested investor, looks to buy shares in companies that they expect to increase in value over time.

A short equity investment strategy by contrast is when hedge fund managers identify companies they believe are set to do badly. They borrow shares in the company and sell them at their current price, say 1200p. The aim is to buy those shares back later after their value has continued to decline and return them to the lender. So, in our example, if the price has fallen to 800p the short seller will make a profit.

By combining a long and short equity strategy the hedge fund manager is trying to get the best of both worlds. Once more ‘hedging their bets’.

However, there are risks with this approach. The long equity strategy may struggle to produce strong returns if the company does not perform as expected because of a failed product, management change or unexpected economic hit. However, as the price of a share can only fall to zero, the most an investor holding a  long position can lose is the amount of their original investment.

A shorting strategy carries more risk because that 1200p example could (if the analysis is wrong and the company performs strongly) grow to many times its original size – resulting in significant losses.

2. Global macro hedge funds

By using this strategy hedge fund managers aim to profit from changes in the markets caused by political and/or economic events. After research and analysis, they take short or long positions in a variety of assets such as equities, bonds, currencies or commodities ahead of the event.

A good example is the Brexit referendum vote in the UK in 2016. Before the polling day hedge fund managers took up several positions in anticipation of the outcome. Some went long on gold expecting investors to rush to safe havens in the event of the UK voting to leave the EU and short positions on European equities and sterling with the expectation that their value would tumble.

Positions can be taken on a particular outcome or to profit from the general volatility in markets which tend to follow huge events such as Brexit or a general election.

3. Relative value hedge funds

With this strategy, hedge fund managers look to take advantage of price differences between related assets such as equities, bonds, currencies and commodities. An example could be the market’s response to a company set to make a takeover of a rival. Perhaps, unsure about the rationale behind the move, its share price suffers but the price of the bonds it issues are less affected.

A hedge fund manager could then look to go long and buy up some shares and go short on the bonds in the hope that the market has overreacted and under-reacted in both areas.

Another example of a relative value strategy could be exploiting different parts of the bond market with divergent views on interest rates or inflation.

4. Activist hedge funds

In corporate life, an activist hedge fund manager takes a significant stake in a business and tries to use their influence as a shareholder to make changes. That could be pushing for a new chief executive, a change in business strategy, a break-up of the business, a sale or an acquisition. The aim of the changes is to make the company perform better, boosting its share price in order to make a profit.

5. Trend following/CTA hedge funds

Trend strategies or Commodity Trading Advisors (CTAs) seek to exploit trends and momentum in prices, typically using exchange-traded futures contracts. They can be utilised across all asset classes including equities, bonds, currencies and commodities and can benefit from being long or short in any of them.

How do UK investors access and invest in hedge funds?

Hedge funds have a reputation for being difficult to access and expensive. However, the above hedge fund strategies are available to all investors in a variety of other ways. This includes as an investment trust listed and trading on stock exchanges like company shares, and the targeted absolute return sector, which is also home to open-ended funds with a variety of long/short equity and bond strategies, as well as global macro funds.

There are a lot of hedge funds pursuing very different strategies and investors need to know what they are buying. Careful analysis is vital in getting the right outcome for an individual portfolio.

Hedge funds can be complex products aimed at professional or experienced investors who are comfortable with taking different risks and paying higher fees. Some hedge fund managers buy and sell a wide variety of financial securities and employ sophisticated strategies. This means there can be additional financial risks which may not be present in other investments. Anyone considering them for a portfolio should make themselves aware of the specific risks and seek professional advice.

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Important information

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

The value of an investment may go down as well as up and you may get back less than you originally invested.

Targeted absolute return funds do not guarantee a positive return and you could get back less than you invested as with any other investment. Additionally, the underlying assets of these funds generally use complex hedging techniques through the use of derivative products which can carry additional risks which may not be immediately apparent.

Funds that invest in specific sectors may carry more risk than those spread across a number of different sectors. In particular, gold, technology and other focused funds can suffer as the underlying stocks can be more volatile and less liquid.