Alternative Investments: Hedge Funds

The second generation of hedge funds took the original idea behind long-short investing - trying to make money whichever way a market was heading - and adopted a precision approach which takes the 'up' or 'down' decision out of the equation.

A long-short fund takes independent long and short positions. It still relies on identifying direction. Market risk is roughly reduced by holding a mixture of 'up' and 'down' stock-picking views. A market neutral fund removes market risk by ignoring direction. It is looking to to identify an asset which will outperform another asset, in whichever direction.

This is a radical departure from investing in direction. A market neutral fund takes investment decisions in pairs. The idea is to find a pair of assets whose price movements are related, then go long the outperformer and short the underperformer. To be market neutral, the same cash amount is invested in both positions.

So instead of taking a view that A will go up, you take a view that A will outperform B, whether down or up. Going long A and short B, if A rises and B falls, a clear profit will be made on both positions. But if both rise or both fall, a net profit will still be made providing the long position outperforms the short.

So a pair of long-short positions is less risky than a single position because it will make a net profit in any circumstances provided the long position outperforms the short position. It will only lose money if the spread moves against the investor and the short position outperforms the long position. Market neutral investing requires in-depth research into the relationship between two prices.

Funds typically use quantitative analysis - the statistical analysis of past price movements - to discover pairs of assets with a strong historical relationship. Two possible interrelationships will be profitable, whether up or down in price.

Relative value strategies can be applied to any asset class or market as long as a price relationship is apparent. Funds usually specialize in equity or debt. Equity market neutral funds are by far the most common, and lowest risk. Event-driven equity funds tend to be higher risk. In banking circles, relative value strategies are called 'arbitrages' so Fixed Income Arbitrage Funds look for relative value trades in bond markets.