Traditional portfolios generally rely on stocks for growth and bonds for diversification and stability. Hedge funds take a different approach, using specialized strategies that seek returns from security selection, market inefficiencies or relative-value opportunities, rather than relying solely on rising markets.
That flexibility is one reason investors often turn to hedge funds when markets become more volatile, correlations increase, or traditional diversification becomes harder to find.
Key takeaways
- Flexibility matters. Hedge funds can invest across asset classes and use tools that traditional mutual funds may not.
- Returns can come from skill, not just markets. Many hedge fund strategies seek opportunities regardless of whether markets rise or fall.
- Not all hedge funds are alike. Strategies, risk profiles, liquidity terms, and outcomes can vary significantly across managers.
How do hedge funds generate returns?
Hedge fund returns often come from identifying opportunities that other investors may overlook, unlike traditional stock or bond portfolios that depend largely on market direction.
Common sources of return include:
- Security selection. Managers seek to identify securities they believe are mispriced relative to their fundamentals.
- Relative value opportunities. Managers may buy one security while selling another to profit from pricing differences between related assets.
- Macro themes. Managers express views on interest rates, currencies, commodities, economic growth, or policy developments.
- Event-driven opportunities. Managers invest around corporate events such as mergers, restructurings, or spin-offs.
- Risk management. Many hedge funds use hedging techniques intended to reduce exposure to broad market movements.
DECODED INSIGHT: Hedge fund returns are often driven by manager skill. Many traditional portfolios depend heavily on the direction of markets. Many hedge fund strategies, by contrast, seek opportunities created by security selection, market dislocations, or relative-value relationships. As a result, outcomes can vary significantly between managers pursuing similar strategies.
What are the main types of hedge funds?
Hedge funds vary widely in how they invest, but most strategies can be grouped by the types of opportunities they pursue. The main hedge fund strategies are equity hedge, credit, event-driven, multi-strategy, and macro.
| Strategy | What it does |
| Equity Hedge | Takes long and short positions in equities, using fundamental or quantitative analysis to seek returns from stocks expected to rise or fall. |
| Credit | Takes long and short positions in credit instruments, seeking returns from yield or changes in an issuer’s creditworthiness. |
| Event-Driven | Seeks opportunities created by company-specific events such as mergers, acquisitions, bankruptcies, reorganizations, or spin-offs. |
| Multi-Strategy | Invests across markets, asset classes, and strategies, often using relative-value approaches to diversify sources of return and manage downside risk. |
| Macro | Takes positions across global markets based on expected changes in economic conditions, interest rates, currencies, commodities, or policy. |
What do hedge funds add to a portfolio?
Hedge funds can add three things to a portfolio: diversification potential, risk management tools, and flexibility.
- Diversification potential. Returns may be driven by factors other than broad stock and bond markets.
- Risk management tools. Many strategies use short selling, hedging, or other techniques intended to reduce market exposure.
- Flexibility. Managers can often invest across asset classes, geographies, and market environments.
DECODED INSIGHT: Risk-adjusted returns consider both sides of the equation. A strategy’s return tells only part of the story. The Sharpe ratio also considers the volatility experienced in generating that return, providing a way to compare results across different strategies and market environments.
What are the risks of hedge funds?
The main risks and considerations for hedge funds are manager selection, liquidity, leverage, and fees.
- Manager selection. Different managers pursuing similar strategies may deliver very different outcomes. Wide performance dispersion makes manager evaluation particularly important.
- Liquidity. Many hedge funds offer periodic redemptions rather than daily liquidity and may include lockups, notice periods, or gates.
- Leverage. Some hedge funds use borrowed capital to increase exposure, which can amplify gains and losses.
- Fees. Many hedge funds charge both management fees and performance-based incentive fees, in addition to operating expenses.
Myth vs. Fact: Common questions about hedge funds
| Question | Answer |
| Do hedge funds always take excessive risk? | Many hedge fund strategies are designed specifically to manage risk or reduce market exposure. |
| Do hedge funds only make money when markets rise? | Some strategies seek opportunities regardless of market direction. |
| Do all hedge funds invest the same way? | Hedge funds encompass a wide range of investment approaches and objectives. |
The Bottom Line: What should investors know about hedge funds?
Hedge funds pursue returns differently than traditional stock and bond portfolios. By using a wide range of strategies, investment tools and risk-management techniques, they seek opportunities that may behave differently across market environments. Understanding how those returns are generated, and the trade-offs involved, can help investors determine what role hedge funds may play as part of a diversified portfolio.
INDEX DEFINITIONS
HFRI Multi-Manager/Pod Shop Index: The HFRI Multi-Manager/Pod Shop Index is comprised of funds of various strategy types that utilize a multi-manager or “Pod Shop” structure, whereby fund capital is allocated to multiple independent investment teams referred to as “Pods.” The Pods are autonomous but generally operate within certain portfolio management or risk guidelines, and capital is allocated to or from these Pods in a discretionary manner under the supervision of a Chief Investment Officer.
HFRI Relative Value Multi-Strategy Index: Multi-Strategies employ an investment thesis is predicated on realization of a spread between related yield instruments in which one or multiple components of the spread contains a fixed income, derivative, equity, real estate, MLP or combination of these or other instruments. Strategies are typically quantitatively driven to measure the existing relationship between instruments and, in some cases, identify attractive positions in which the risk adjusted spread between these instruments represents an attractive opportunity for the investment manager. In many cases these strategies may exist as distinct strategies across which a vehicle which allocates directly, or may exist as related strategies over which a single individual or decision making process manages. Multi-strategy is not intended to provide broadest-based mass market investors appeal, but are most frequently distinguished from others arbitrage strategies in that they expect to maintain >30% of portfolio exposure in 2 or more strategies meaningfully distinct from each other that are expected to respond to diverse market influences.
Bloomberg U.S. Aggregate Bond Index: A broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market.
Bloomberg U.S. Long Treasury Index: Measures the performance of U.S. Treasury securities with longer-term maturities.
S&P 500 Total Return Index: Measures the total return of the S&P 500, including both changes in the prices of the index constituents and reinvested dividends.
ICE BofA MOVE Index: Measures expected volatility in the U.S. Treasury market based on options pricing across several Treasury maturities.
Constructed 60/40 Portfolio: A hypothetical portfolio consisting of 60% S&P 500 Total Return Index and 40% Bloomberg U.S. Aggregate Bond Index.
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