Types of Hedge Funds

Equity Hedge Funds
Equity hedge funds include those categories that invest primarily in com-
mon stocks.
Equity Long Biased
This group of hedge funds is the most familiar style to
many people. The group may carry short positions, but the size of the long
positions is usually larger than the size of the short positions. This group is
one of several styles that are included in the broader category in Figure 2.2
and 2.2. The managers usually seek to generate returns by selecting a nar-
row portfolio of common stocks. Individual managers may seek to supple-
ment the returns from stock selection by overlying a market-timing
strategy. The stock selection may be based on fundamental analysis or, less
commonly, on technical analysis. Often, hedge funds employ proprietary
strategies to construct the portfolio. The portfolios in this group generally
have low leverage (2 to 1 or less).
The equity long biased hedge funds have produced returns somewhat
higher than broad equity returns, with risk (volatility of returns) about
equal to index returns. Not surprisingly, the performance of long biased
hedge funds correlates highly with stock returns (70 percent) but not par-
ticularly with interest rates. The VIX index measures implied volatility on
equity options. Correlation between the long biased funds and this mea-
sure is high but somewhat less than stock index returns.
Equity Market Neutral
Equity market neutral hedge funds may use a vari-
ety of strategies. Arbitrage trading includes trading between futures and
underlying common stocks (basis or basket trading), buying and selling re-
lated classes of common stock (pairs trading) or certain options strategies.
The category also includes hedge funds that balance long and short posi-
tions (matched issue by issue or as a portfolio) to hedge market impact.
Equity market neutral hedge funds have provided returns about equal to
those of broad indexes while assuming much less risk than a portfolio of
common stocks (perhaps half the volatility of returns of the S&P 500 index).
Despite the name given to this category, the group remains somewhat linked
to market stock returns (30 to 40 percent). The equity market neutral hedge
funds are much less linked to uncertainty in the financial markets than a tra-
ditional pool of common stocks. The correlation of the S&P 500 index to
the VIX index of volatility is above 65 percent versus the equity hedge funds,
which have a correlation about 20 percent to the VIX index.
Equity Arbitrage
This strategy is sometimes incorporated in the equity
market neutral category. While the equity market neutral group is broad
Types of Hedge Funds
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