A Taxonomy of Hedge Fund Strategies
Hedge funds get lumped together in the press, but the strategies inside them borrow risk from completely different sources — equity direction, credit spreads, volatility, merger outcomes — and knowing which one you're looking at tells you what actually makes it lose money.
Prerequisites: Equity Market Neutral
"Hedge fund" describes a legal wrapper, not a strategy. A long/short equity fund, a merger-arbitrage fund, and a macro fund charging the same 2-and-20 fee can have almost zero correlation to each other, because each one is harvesting a completely different source of risk. Sorting funds by the risk they're actually selling — not by their marketing deck — is the first step in knowing what will make any given one blow up.
Sorting by risk source, not by asset class
Two funds that both trade equities can be unrelated bets. A long-only stock picker and a market-neutral stat arb fund both hold equities, but one is selling market-direction risk and the other has hedged it away and is selling something narrower: the risk that its residual signal stops working (see Equity Market Neutral). The useful taxonomy groups funds by what risk they're paid to bear, in four rough buckets.
Directional. Long/short equity, global macro, managed futures. These funds carry net exposure to a market, a rate, or a currency moving in a particular direction. Their risk is straightforward: they are wrong about direction. A macro fund short the yen against a rate-differential thesis loses when the Bank of Japan surprises it.
Relative value. Fixed income arbitrage, convertible arbitrage, capital structure arbitrage. These funds are close to market-neutral on the first-order risk and instead bet on a relationship between two related instruments converging — a bond and its swap, a convertible and the underlying stock. Their risk is that the relationship breaks rather than converges, usually because both legs get hit by the same liquidity shock at once.
Event-driven. Merger arbitrage, distressed debt, special situations. These funds are paid for underwriting a specific corporate outcome: a deal closing, a bankruptcy resolving. A merger-arb fund buying the target at $48 against a $50 cash offer is effectively selling insurance on deal completion — the spread is compensation for the (usually small) chance the deal breaks.
Volatility and correlation. Options-based funds trading dispersion, variance swaps, or tail hedges. These funds are paid or pay for the difference between what volatility markets expect and what actually happens.
Worked example. A merger-arb fund buys 100,000 shares of a takeover target trading at $48.00 against a signed $50.00 all-cash offer, an annualized spread of roughly 4% over the expected six-month close if nothing goes wrong. If the acquirer's shareholders approve and the deal closes on schedule, the fund earns $2.00/share, or $200,000 on the position. If antitrust review kills the deal and the stock falls back to its $38 pre-announcement level, the fund loses $10.00/share, or $1,000,000 — a payoff that looks exactly like a short put: small steady premium most of the time, a large loss on the tail event.
Classify a fund by the specific event that ends its edge, not by what asset class shows up in its holdings. A convert-arb fund and a merger-arb fund can both hold equities and still fail for entirely unrelated reasons.
In interviews
Be ready to place an unfamiliar strategy into one of the four buckets by asking "what is this fund paid to bear, and what single event ends that payment?" That question is also the fast way to answer "how could this fund lose money" for any strategy an interviewer names cold.
Don't confuse low historical volatility with low risk. Merger-arb and convertible-arb both produce smooth return streams most of the time precisely because they're short an infrequent tail event — the smoothness is the premium being collected, not evidence the risk is small.
Practice in interviews
Further reading
- Lhabitant, Handbook of Hedge Funds (ch. 2–4)