Key Hedge Fund Strategies

Why This Matters

Hedge fund strategies sit at the intersection of corporate finance, market structure, and risk management—three pillars you'll encounter repeatedly in M&A and complex financial structures. When a private equity firm launches a hostile takeover, merger arbitrageurs are placing bets on the outcome. When a company enters bankruptcy, distressed securities funds are negotiating with creditors. Understanding these strategies helps you see deals from multiple angles: the principals executing transactions and the sophisticated investors positioning around them.

You're being tested on more than definitions here. Exam questions will ask you to identify which strategy fits a given market scenario, explain how different approaches generate alpha, and analyze the risks inherent in each. The key concepts include market neutrality, event catalysts, relative value, and systematic versus discretionary approaches. Don't just memorize strategy names—know what market inefficiency each exploits and when it performs best.

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Market-Neutral Equity Approaches

These strategies attempt to isolate stock-picking skill from broad market movements. By pairing long and short positions, managers aim to profit from relative performance rather than market direction.

Long/Short Equity

• Core mechanism: simultaneous long and short positions—buy undervalued stocks while shorting overvalued ones to capture the spread between them
• Market exposure varies by net positioning; a fund 130% long and 30% short has 100% net long exposure versus a market-neutral fund at 0% net
• Fundamental analysis drives selection, requiring deep research into earnings quality, competitive positioning, and valuation metrics

Convertible Arbitrage

• Exploits mispricing between convertible bonds and underlying equity—buy the convertible, short the stock to isolate the embedded option value
• Delta hedging adjusts the short position as the stock price moves, capturing profits from volatility while neutralizing directional risk
• Credit risk and liquidity matter; convertibles from distressed issuers carry default risk that pure arbitrage models may underestimate

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Event-Driven Strategies

These approaches profit from specific corporate actions rather than broad market trends. The catalyst is identifiable and time-bound—a merger announcement, bankruptcy filing, or restructuring plan.

Event-Driven (General)

• Invests around corporate catalysts—mergers, spin-offs, restructurings, and regulatory decisions that create price dislocations
• Time horizon is defined by the event, typically weeks to months rather than years
• Legal and regulatory analysis is critical; understanding antitrust review, shareholder approval requirements, and deal conditions separates winners from losers

Merger Arbitrage

• Captures the spread between current price and deal price—if Company A offers $\$50$ per share for Company B trading at $\$47$, the arbitrageur buys B and profits when the deal closes
• Short the acquirer in stock-for-stock deals to hedge against changes in the exchange ratio
• Deal break risk is the primary threat; spreads widen when regulatory concerns or financing issues emerge

Distressed Securities

• Targets companies in financial distress or bankruptcy—buying debt at steep discounts with the expectation of recovery through restructuring
• Fulcrum security identification is key; the debt tranche most likely to convert to equity controls the restructuring outcome
• Active involvement often required; distressed funds frequently join creditor committees and negotiate reorganization plans

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Macro and Systematic Approaches

These strategies take positions based on broad economic themes or quantitative signals rather than individual security analysis. The focus shifts from company fundamentals to macroeconomic variables, price patterns, and statistical relationships.

Global Macro

• Top-down approach analyzing GDP growth, inflation, central bank policy, and geopolitical events across regions
• Multi-asset class exposure—currencies, interest rates, commodities, and equity indices all serve as expression vehicles
• Discretionary judgment dominates; managers like George Soros famously bet against the British pound based on policy analysis

Managed Futures/CTA

• Systematic trend-following using futures contracts across commodities, currencies, and financial instruments
• Commodity Trading Advisors (CTAs) typically employ algorithmic models that identify and ride price momentum
• Crisis alpha potential—managed futures often profit during equity market crashes when trends accelerate, providing valuable diversification

Quantitative Strategies

• Algorithm-driven decision making using statistical models, machine learning, and large datasets
• High-frequency trading (HFT) represents one extreme, capturing tiny price discrepancies thousands of times per day
• Factor exposure underlies many quant approaches; models may systematically harvest value, momentum, or quality premiums

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Relative Value and Arbitrage

These strategies exploit pricing discrepancies between related securities, aiming for profits regardless of market direction. The core assumption is that mispricings will correct as markets recognize fair value.

Fixed Income Arbitrage

• Exploits price discrepancies in bonds and interest rate derivatives—going long undervalued securities while shorting overvalued related instruments
• Leverage amplifies small spreads; because mispricings are often tiny, funds use significant borrowed capital to generate meaningful returns
• Interest rate and credit risk must be carefully managed; the 1998 LTCM collapse demonstrated how fixed income arb can unravel during market stress

Multi-Strategy

• Combines multiple approaches within a single fund, allocating capital dynamically across long/short equity, event-driven, relative value, and macro strategies
• Diversification benefit reduces dependence on any single market environment or strategy performing well
• Internal capital allocation allows rapid redeployment; when merger spreads widen, capital can shift from equity to event-driven without investor redemptions

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Quick Reference Table

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Self-Check Questions

1. Which two strategies both use paired long/short positions but differ in their underlying instruments? Explain what each is actually arbitraging.

2. A company announces it will acquire a competitor for $\$85$ per share in cash, but the target currently trades at $\$81$. Which strategy would exploit this situation, and what is the primary risk?

3. Compare and contrast Global Macro and Managed Futures/CTA. What distinguishes discretionary from systematic approaches, and when might each outperform?

4. A distressed securities fund and a merger arbitrage fund both invest around corporate events. How do their analytical frameworks and time horizons differ?

5. If an FRQ describes a fund that dynamically shifts capital between equity hedging, merger spreads, and interest rate trades depending on market conditions, which strategy classification applies? What advantage does this structure provide?