Define hedge fund
Although simple in theory, proper execution of this strategy requires careful timing to avoid losses. Convertible arbitrage seeks to profit from price inefficiencies of a company’s convertible securities relative to its company’s stock. Typically, fixed income arbitrage strategies include swap-spread arbitrage, yield curve arbitrage, and capital structure arbitrage.Īt its most basic level, convertible arbitrage involves taking long positions in a company’s convertible securities while simultaneously taking a short position in a company’s common stock. Most commonly, by taking various opposing positions in inefficiently priced bonds or their derivatives, with the expectation that prices will revert to their true value over time. It had to be bailed out by a government-brokered consortium of Wall Street banks.įixed income arbitrage seeks to exploit pricing differences in fixed income securities. Long Term Capital Management suffered catastrophic losses. One of the more memorable examples of this type of loss was Long Term Capital Management, the infamous fixed income arbitrage fund from the 1990s. Due to heavy use of leverage, some arbitrage firms have suffered monumental losses when pricing differences shifted unexpectedly. However, because price inefficiencies between investments tend to be slight, arbitrage funds must rely heavily on leverage to obtain significant returns. When properly used, arbitrage strategies produce consistent returns with low risk. A conventional fixed income hedge fund strategy is fixed income arbitrage, discussed below.Īrbitrage strategies seek to exploit observable price differences between closely-related investments by simultaneously purchasing and selling investments. Many fixed income funds have lower risk tolerances than distressed debt funds and place capital preservation as a higher priority, leading to more diversification and volatility-reducing strategies. They have a finite duration, typically between five and ten years.įixed income funds invest in long-term government, bank and corporate bonds, debentures, convertible notes, capital notes, and their derivatives, which pay a fixed rate of interest. Unlike hedge funds that allow regular withdrawals, private equity funds are usually closed-ended. A fund sponsor looking to form a distressed debt fund should speak with experienced legal counsel to determine whether a private equity fund would be more appropriate. Hedge funds that invest in distressed debt need to employ more stringent lock-up and withdrawal terms, including side pockets, (accounts to separate illiquid assets).
Distressed debt funds use fundamental analysis to identify undervalued investments. When a company is unable to meet its financial obligations or is in a liquidity crisis, its debt devalues. Credit funds include distressed debt strategies, fixed income strategies, direct lending, and others.ĭistressed debt involves investment in corporate bonds, bank debt, and occasionally common and preferred stock of companies in distress. Credit funds tend to follow cyclical patterns and are most active following economic downturns and restrictions in the credit market. Accordingly, lock-ups, gates, and other withdrawal terms are usually on the more permissive side because of the ease of liquidating positions when needed to facilitate investor withdrawals.Ĭredit funds make debt investments based on lending inefficiencies. Long/short funds also tend to have reasonably straightforward investment fund terms. Long/short funds tend to invest primarily in publicly traded equity and their derivatives and tend to be long-biased. Funds using a long/short strategy employ a wide range of fundamental and quantitative techniques to make investment decisions. As the name suggests, the long/short equity strategy involves taking long and short positions in equity and equity derivative securities. One of the most commonly used strategies for startup hedge funds is the long/short equity strategy.
To learn more about forming and operating a hedge fund, we encourage you to read our eBook, Forming and Operating a Hedge Fund. Hedge fund investment terms are driven in large part by the fund’s strategy and its level of liquidity. The horizon of hedge fund investment strategies has seen unprecedented expansion in recent years. Hedge fund strategies encompass a broad range of risk tolerance and investment philosophies within a wide array of investments, including debt and equity securities, commodities, currencies, derivatives, real estate, and other investment vehicles.