Types of Hedge Funds

returns). The performance is fairly correlated to stock returns (50 percent)
and has a fairly high correlation to market uncertainty (correlation to VIX
around 40 percent).
Risk Arbitrage
Risk or merger arbitrage generally involves buying the tar-
get company of a takeover after an attempt is announced and selling short
the acquiring company. Although complicated terms may require more
complicated positions, the typical position includes a long position that
can be delivered to close out the short position if the deal is completed.
3
Risk arbitrage provides relatively low returns (somewhat less than
stock returns), compared to other hedge fund strategies but involves rather
low risk. Early returns were higher than recent and a wave of deals may
raise the return in the future. Returns remain highly correlated to stock re-
turns (45 to 50 percent) and are sensitive to market uncertainty (correla-
tion to VIX around 50 percent).
Regulation D
This group of hedge funds buys private equity positions in
young, often very small companies. Frequently, these investments may be
structured as convertible bonds with features designed to provide down-
side protection.
Performance on this section ranks among the highest of hedge fund
strategies, up to twice the return on the S&P 500 index. Return volatility is
very low when based on monthly net asset value (NAV) data, but the NAV
is probably not as stable as the data suggest. The returns on private equity
positions are frequently more volatile than the reported performance
would indicate because hedge funds often don't mark private equity posi-
tions to market. Likewise, a low correlation to the VIX index probably un-
derstates the sensitivity of these positions to market sentiment.
Convertible Arbitrage
Convertible bonds and convertible preferred stock
are fixed income instruments that may be exchanged for common stock.
The typical issuers of convertible securities are young and fast growing and
have a low debt rating. The debt structure might appear to offer some
downside protection if the investor expects to get back the full principal
value of the investment as a worst case. In practice, the market value of the
debt is usually closely tied to the market value of the common stock be-
cause the company can reliably repay the bonds if the company does well,
and if the company does well the common stock does well.
The option to convert is an option to exchange the bonds for stock.
This type of option is more difficult to value than a simple call option. To
further complicate matters, convertible securities may include call options,
put options, and features to force the holder to convert to stock.
Types of Hedge Funds
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