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What types of hedge fund are there?

For those interested in the world of investing, hedge fund is a term you’ve likely come across. But as there are several different types of hedge fund, we thought we’d take the time out to explain them all.

What is a hedge fund?

A hedge fund is a collective investment fund where those who manage it use a range of investment strategies to beat average investment returns for their clients. The investment strategies or asset classes they use tend to be non-traditional and risky.

Generally, hedge funds charge much higher fees than conventional investment funds and require high minimum deposits, meaning their clients are usually exceptionally wealthy.

Famously, the US-based online brokerage firm Robinhood caused hedge funds to lose billions of dollars earlier this year when it got involved in the GameStop short-squeeze.

There are several types of hedge fund.

Global macro hedge fund

Global macro hedge funds make investment choices based on the broad economic and political outlook for various countries, and they attempt to profit from broad market swings caused by political or economic events.

As such, global macro hedge funds may position themselves around a particular outcome, making a market bet using a variety of assets and instruments, including futures, currencies, index funds, bonds and commodities.

One example of a global macro hedge fund in practice was the Brexit vote in 2016. Prior to the vote, global macro hedge funds who predicted Britain would vote leave, took long positions in safe assets, like gold, and short positions in the British pound and European stocks.

Directional hedge funds

Directional hedge funds do not fully hedge. A hedge is an investment that is made in the hope of reducing the risk of adverse price movements in assets. So, in directional hedge funds, there is some exposure to the stock market, but those who control the fund try to achieve returns that exceed the level of risk taken.

Event-driven hedge fund

An event-driven hedge fund attempts to profit from a stock mispricing that has occurred either before or after a corporate event has taken place.

There are various types of corporate event, including mergers and acquisitions, regulatory changes, earnings calls, restructurings and spinoffs. Generally, a team of specialists will analyse corporate actions from a variety of perspectives and recommend an investment strategy based on their findings.

Relative value hedge funds

Relative hedge funds seek to exploit temporary differences in the prices of related securities. After working out whether an asset is under or overvalued, they will buy and sell accordingly.

One of the most common strategies this type of fund employs is pairs trading, which involves initiating a long and short position for a pair of assets that are highly correlated.

Merger arbitrage

Merger arbitrage is a specific type of relative hedge fund that involves purchasing and selling the respective stock of two merging companies at the same time.

Typically, the uncertainty of the deal being completed causes the stock price of the target company to sell below the acquisition price. So, the hedge fund will buy shares in the target company and short sell the buying company’s shares in the hope of making a profit when the merger or acquisition is complete.