Introduction to Hedge Funds Strategies
For decades, hedge funds have been at the forefront of making Wall Street what it is today. This has happened because of a number of factors such as their massive war chest, alpha performance, and their managers massive display of their wealth.
A documentary detailing the lavish lifestyle of hedge funds showed them living in large mansions, flying fancy private jets, buying expensive art collections, and giving millions of dollars in charity.
However, in the recent past, hedge funds has been a troubled industry.
Some of the largest hedge funds such as Pershing Square Capital Management, Bridgewater Associates, and Janus Capital have suffered substantial losses. This has partly been blamed by the ‘new game in town’: quantitative hedge funds strategies.
1. Quantitative Trading
Quantitative trading is the use of computing and mathematical techniques to perform analysis. It involves combining a number of mathematical ideas to achieve a certain goal.
For instance, a trader can create a formula that places a buy trade when certain points of technical indicators are reached. In the past, the performance of quant hedge funds has been better than their other peers.
For instance, in 2008 when most hedge funds reported losses, the James Simons’ led Renaissance Technologies reported a 80% jump in profits.
Other large quant hedge funds include: Citadel (led by Ken Griffin), Bridgewater Associates (led by Ray Dalio), D.E. Shaw, and Quantitative Management Associates among others.
Below we illustrate you five key lessons to learn from the largest quantitive hedge funds strategies.
→ 5 Reasons Why Quantitative Trading Is The Future of Trading
#1 - Importance of Mathematics
The first main lesson from the success of quant hedge funds is on the importance of mathematics in the financial industry. This is why these funds mostly employ people with a statistic and physics background.
Think about it: More than 85% of employees of James Simons’ Renaissance Technologies don’t have a background in business and finance. The same is the case of other large quant hedge funds.
#2 - Power of less talk
On a daily basis, you will see hedge fund managers in the top financial media such as CNBC and Bloomberg. These are hedge fund managers who use the traditional trading strategies such as activist investing, and long/short theories.
But We have only watched a few interviews with the quant strategists. This is partly because most of these hedge fund managers don’t care about the performance of the economy as shown below.
#3 - Power of Early Adoption
Every industry is being disrupted by a form of technology.
The automobile industry is being disrupted by the autonomous and electric vehicles; Communication has been disrupted by tools such as Whatsapp and Facebook; The transport industry has been disrupted by carpooling and ride hailing applications.
The hedge fund industry is now being disrupted by bots and quant trading.
In fact, most hedge funds are now shifting gears to quant trading. In this, early adopters of the technology such as the hedge funds mentioned above will be at a better place to make money than the late comers.
#4 - Power of Hedging
Hedging is perhaps one of the most important thing ever invented in finance and trading. Hedging allows an investor to benefit regardless of the direction of the market.
For instance, in a bull market, bear hedge funds make losses and vice versa. Quant strategies ensure that the hedge fund managers are protected in case of the downside at all time. They buy and sell at the same time.
This is one area that day traders need to focus on: protecting their accounts through hedging.
#5 - Power of less
Most hedge funds value large/big. This is the exact opposite of most quant hedge funds! For instance, with more than $65 billion in AUM, Renaissance Technologies have only about 400 employees. This compares to other smaller funds with thousands of employees.
As a trader, you need to appreciate the power of less. Yes, you don’t have a lot of money but you can always achieve better success by being disciplined.
→ A brief guide to quantitative trading
2. Arbitrage Strategy
Most hedge fund managers use this strategy to hedge against a downside. Arbitrage is a term that simply means pairs trading where you buy a certain ‘asset’ while shorting a related ‘asset’.
For instance, generally, if the price of oil is falling, we expect that BP and Exxon will both fall. Using arbitrage, you can buy BP (LSE) while shorting Exxon (NYSE). You will therefore gain from the spread if your theory becomes true.
Alternatively, if company A is being bought by company B, then you can short company B while going long A. This is known as merger arbitrage. It is also possible to do arbitrage in one company where you short its shares while going long its bonds. This is known as convertible arbitrage.
3. Event driven
This is a strategy that hedge funds love.
There are so many financial or economic events that you can use to gain alpha. As example, many investors love IPOs. In many cases, when a hot Silicon Valley startup lists, chances are that it goes up. For instance, BOX went up by more than 10% on its inaugural day. Many hedge fund managers shorted the company because they knew that the company would later go down.
Other events such as mergers and acquisition (as stated above) and the earnings season is also ideal for hedge fund managers to maximize their returns.
4. Global Macro
A global macro hedge fund is one that looks at the global economic and financial world and then makes decision based on this.
If for instance a hedge fund manager believes that the Mexican economy will lose ground, then they will short the Mexican Real. In addition, if the economies of the emerging markets are not stable as a result of the weakened commodity prices, then the manager might short the emerging markets.
The benefits of all these? You have the data with you and so you can replicate the strategy (the same concept of Excel's Macro).
Other hedge fund managers follow a multi-strategy approach where they use different strategies and target various sectors.
A good example of such a hedge fund is one that combines arbitrage with quantitative techniques. Also, another example is one which uses various asset classes such as currencies, commodities, and equities to trade.
There are other strategies used by hedge funds that you can apply to your trading. These are: directional (which bases investment on long or short positions only), sector (bases investment on single sectors), long/short equity (buying and shorting stocks), and activism among others.