Risk Profiles of Investors

We can say hedge fund investors generally do not like surprises, especially unpleasant ones. These investors are very demanding and they expect their fund manager to be the best in his claimed field of expertise. Most hedge fund managers are investment professionals with many years of experience and additionally had gone through and understood the consequences or aftermath of major stock market corrections. These managers are very disciplined, diligent, and do not panic easily over a temporary loss. They are also highly specialized and trade only within their specific area of expertise which should result in a distinct competitive advantage. Some hedge fund managers can be very knowledgeable in certain investment areas only. Others have acquired sufficient experience over several narrow areas of expertise and can execute several strategies at once with impressive results. The following will discuss briefly the different strategies with their degree of volatility starting from low to high.

1. Income Strategy – investments are focused on the bond yield or current income rather than on capital gains (price appreciation). This is usually a long position (that is actually buying and holding on to the bond or stock itself) and may sometimes utilize leverage (borrowing additional funds) to buy more stocks or bonds or their derivatives in order to maximize profits from principal appreciation and added interest incomes.

2. Arbitrage Strategy (Market Neutral) – this type of fund tries to remove market risk by the offsetting positions it takes on different instruments issued by the same company. An example will be the fund’s long position in that firm’s corporate bonds but short on its equity stock. The two primary hedging techniques often utilized here are short-selling and interest rate futures. The returns here are not related to market performance, so the expected volatility with this strategy is low.

3. Securities Hedging Strategy (Market Neutral) – this strategy invests in both long and short positions usually within the same market sector/s. The key success factors for this to work are an effective stock analysis and a very selective stock selection based on that stock analysis. Since this is a low-risk strategy, the relative benchmark for this type of fund is the risk-free T-bills rate.

4. Value Strategy – this strategy requires patience since the intrinsic value or worth of a certain stock takes time before it gets noticed in the broad market. These stocks are usually trading at certain discounts either because they are out of favour among the buyers or not being closely followed and watched. The whole intent is to buy these “sleeper” stocks while they are still cheap. Risk is low.

5. “Distressed” Securities Strategy – the fund buys at big discounts the equity, debt instruments or other trade claims against a firm that is either facing bankruptcy or a major business reorganization. This is similar to a “fire sale” where the price is not reflective of the true value of the firm. Risk is low and not market-correlated. These investment instruments are considered to be below investment-grade.

6. “Fund” of Hedge Funds – this particular strategy attempts to blend and mix the various hedge funds’ different asset classes under varying investment strategies to provide a more stable return by taking out the best feature of each fund. The aim of this strategy is primarily capital preservation (conservative approach) rather than a splendid return on investment. It is like having your cake and eating it too! Degree of volatility will depend on the mix of funds that were invested in by this fund.

7. Special Situations Strategy – this type invests only during certain events such as when friendly firms merge, there is a hostile takeover, leveraged buyouts, or major reorganizations. These special situations are considered aberrations in the normal course of business and present an opportunity for a quick buck for the sharp-eyed fund manager. The common technique is to buy shares in the firm to be acquired as well as in the acquiring company, hoping to profit from the difference in prices in these firms before and after the special event has occurred. Expected returns are not related to the overall market although the risk is no longer low but moderate.

8. Opportunistic Strategy – this does not follow any specific or broad investment principle but rather pounces on any opportunity to make a profit that comes along. This is almost similar to the previous strategy mentioned above but it does not try to restrict itself to any particular investment approach. It also does not make any particular preference for any type of asset class. Returns are expectedly variable.

9. Multi-Strategy Approach – this investment style uses a combination of several investment strategies to achieve both short-term and also long-term profits at the same time. This requires a certain degree of flexibility and expertise on the fund’s manager since it employs various diversified technical strategies simultaneously. The expected volatility is variable, depending if the fund can capitalize on certain opportunities quickly enough.

10. Market Timing Strategy – an approach that attempts to allocate fund’s assets among various investment asset types and this requires a high degree of accuracy in the prediction of market or economic movements. Portfolio construction (composition) may vary greatly depending on market direction. It is the difficulty in correctly getting in and getting out of the market at the correct time that makes this approach high volatile. Risk associated with this strategy is considered high.

11. Aggressive Growth Strategy – this investment approach identifies stocks that have high earnings per share but not properly reflected in its market price. These stocks are small-cap stocks but are in specialist high-growth industries. Usually, these stocks have either no or low dividend history but poised to experience rapid growth. Earnings expectations can sometimes be disappointing so short-selling is sometimes resorted to. Although biased towards long positions, this approach can be extremely volatile due to unpredictability of results.

12. Emerging Markets Strategy – this approach invests in less mature markets that offer higher returns but sometimes offset by higher inflation rates and uncertainty of market returns. In these immature markets, short-selling is not allowed by their respective governments to prevent excessive speculation and consequently, there is no appropriate hedge available to the fund manager. Expected volatility is high.

13. Macro Strategy – this approaches investments outlook from a global viewpoint and tries to profit from changes in government policies of some countries. These changes usually affect a country’s interest rate and exchange rate, thereby affecting also its currency, stock and bond markets. A clear example was that of George Soro’s “Quantum Fund” betting against the Bank of England that the pound will be devalued. This also happened with the Thai baht which was the one currency that hedge funds in 1997 focused their speculative attacks on, continually shorting the currency that resulted in its devaluation and sparked the Asian currency crisis. The hedge funds based their strategy on macro-economic factors of the Thai economy at that time, such as its GNP, GDP, exchange rate, foreign currency reserves, etc. This strategy is extremely very risky as it has political implications as well.

14. Short-selling Strategy – this strategy involves short sales which is a variation of the usual “buy-low and sell-high” trading transaction, except the order is reversed and instead becomes “sell-high then buy-low”. The fund manager sells stocks which he considers overpriced right now (by borrowing these stocks, the manager sells stocks he does not yet own) and then buy them at a future date when their prices go down and returning the borrowed stocks. Profit is the difference in price. This is an extremely risky move if the market turns the wrong way.


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