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Ten Strategies Hedge Funds Use to Make Huge Returns, and You Can Too

Lee Jackson

One of the main reasons that the ultra rich have become so enamored with the hedge fund industry over the years is their “go anywhere, do anything” approach to investing. Hedge funds are not regulated in the same way that mutual funds, exchange trade funds (ETFs) and unit trusts are. While they do make periodic filings of holdings, hedge funds within the United States are also subject to regulatory, reporting and record-keeping requirements. Transparency is often avoided, as they do not want copycat trades or their strategies being used. One thing is for sure, hedge funds have been known to use every legal (and some not so legal) trick in the book to generate alpha and outsized returns for their investors.

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The larger the return, often the bigger the fees. We recently wrote about how the existing and changing hedge fund fee structures, the 2% management fee and 20% of performance, is becoming a thing of the past. Here are 10 of the top strategies used by hedge funds to generate returns for their clients.

1. Leverage, or borrowed money, is more of a tactic than a strategy. The use of leverage has been one of the best and worst tactics employed by hedge funds over the past 20 years. When done right, and used in a reasonable manner, strong trading or investment returns are increased by the extra money that is put to work. When done wrong, leverage can exacerbate a sell-off as the hedge fund receives margin calls and is forced to sell positions to meet them. Some hedge funds have used leverage as high or higher than 100 to one. In other words, for every dollar they manage, they borrow $100. That can be dangerous if the market turns against you, regardless of the asset class.

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2. Long Only is a strategy in which a hedge fund owns long positions in stocks and/or other assets, basically looking for alpha to the upside to outperform their benchmarks. If the S&P 500 is a fund's benchmark and is up 10%, and the hedge fund is up 15%, the extra 5% between the two is the alpha generated by the portfolio manager.

3. Short Only is a very difficult strategy in which the hedge fund only sells stock short. Portfolio managers running short only portfolios have been absolutely crushed over the past couple of years as the rising market tide has lifted most boats. There have been solid fundamental shorts where the story had dramatically changed. BlackBerry Ltd. (BBRY) was a perfect example. Once the undisputed leader in cell phones for business, the smartphone revolution crushed the demand, and the company is now seeking a buyer.

4. Long/Short is a strategy where the hedge fund is long or owns stock and also sells stock short. In many cases the trades are called a pair-trade. This is a trade where the fund matches stocks in the same sector. For instance they would be long a semiconductor stock like Intel Corp. (INTC) and short NVIDIA Corp. (NVDA). This gives the hedge fund sector exposure on both sides of the trade. A typical hedge fund exposure would be 70% long and 30% short for a net equity exposure of 40% (70% - 30%).

5. Market Neutral is a strategy accomplished in two ways. If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero. For example, if 50% of funds were invested long and 50% were invested short, the net exposure would be 0% and the gross exposure would be 100%. The perfect market for this strategy is a grinding, sideways, trading market. Huge moves up or down would tend to negate the other side.

6. Relative Value Arbitrage is often a strategy used at hedge funds that trade debt. A portfolio manager would buy two bonds with the same maturity and credit quality, but a different coupon, say one 5% and one 7%. The 7% bond should trade at a premium to par while the 5% bond stays at or below par with the lower coupon. The trade is selling the premium bond at say $1,050 and buying the par bond at $1,000 or less. Ultimately the premium bond will mature at par as will the lower coupon bond. The manager factors in the 2% coverage in the coupon difference against the gain on the short of the premium bond.

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7. Equity Arbitrage funds typically look for takeovers, especially ones that are done with stock or stock and cash. Recently Verizon Communications Inc. (VZ) announced it was buying the remaining share of Verizon Wireless from Vodafone Group PLC (VOD). While there is a large amount of cash and debt involved for Verizon, there is also $609 billion in stock in the deal. The portfolio manager would short the Verizon stock and go long or buy the Vodafone stock. The thought is that the acquirer will trade down and the acquisition target trades up.

8. Distressed Debt is a unique area that is a narrow and complex sector. This strategy involves purchasing bonds that have lost a considerable amount of their value because of the company's financial instability or investor expectations that the company is in dire straits. In other cases, a company may be coming out of bankruptcy and a hedge fund would be buying the low-priced bonds if their evaluation deems that the company's situation will improve enough to make their bonds more valuable. The strategy can be very risky as many companies do not improve their situation, but at the same time, the securities are trading at such discounted values that the risk-adjusted returns can be very attractive. Often the hedge funds will become involved with actually running the companies.

9. Event-Driven funds strictly look for any item that can move the market up and down. Many have computer programs that constantly scan world headlines looking for even five seconds of lead time. A perfect example was on Friday. Despite a less than stellar jobs number, the market opened up. Within 15 minutes headlines were crossing that said Russian President Vladimir Putin would help the Syrian government if strikes were launched. Immediately the market dropped more than 140 points on the headline. If a fund quickly has that data and can short the S&P 500 seconds in front of the news, it can make big money. Often event-driven hedge funds are more big picture, like the ongoing Syrian situation and companies that may do business there or in the region.

10. Quantitative hedge fund managers often employ computer programmers who comb the statistical models and data looking to find alpha that hide behind market abnormalities. This can be exploited by super high-frequency trading programs that can buy and sell thousands of stocks or futures in an instant. Unfortunately, quant computer programs do not always anticipate market commentary. Some funds lost big back in the May to June bond market rout that was instigated by commentary by Federal Reserve Chairman Ben Bernanke. AHL, the $16.4 billion flagship fund of Man Group, the world’s second-largest hedge fund by assets, lost more than 11% of its net asset value in two weeks alone during that sell-off as a result of its huge bond holdings, according to media reports.

Hedge fund investing, long the financial playground for the rich may become more obtainable for investors. Wall Street firms are putting hedge fund type product together that is being sold in mutual fund type packaging. Every properly allocated portfolio should, if possible, have some capital carved out for alternative investments like hedge funds.

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