Types of Hedge Funds

In its purest form, the convertible arbitrage fund buys the convertible
instrument, sells short the common stock, buys or sells options on the com-
mon stock, and perhaps hedges the interest rate risk(s). In practice, the
fund may not be able to hedge all the risks or may choose to hedge only
some of the risks.
The performance of convertible arbitrage funds approximates the
return of a basket of unlevered common stock, although the volatility of
return is considerably lower for the convertible strategy than for the
stock portfolio. The strategy has fairly low correlation to stock and
bond returns and market uncertainty. It is somewhat sensitive to changes
in credit spreads.
Sector Funds
Sector funds include a collection of long-only or long biased
hedge funds invested in a narrow sector of the stock market. Sector funds
pursue a wide range of sectors, but the most common sector funds involve
health care companies, biotechnology, the technology sector, real estate,
and energy. Because these sectors tend to be volatile anyway, these hedge
funds use little or no leverage. The returns on the individual funds depend
on stock selection, but a major part of the return is determined by the per-
formance of the sector.
These sectors have substantially outperformed broad stock indexes
like the S&P 500 (except for real estate, whose returns have roughly
matched the S&P). The returns published by the major hedge fund data
providers for most sector funds have been more or less as volatile as stock
returns, which means they are much more volatile than most other hedge
funds. Because of their narrow concentration, their performance is rela-
tively uncorrelated with broad market returns (30 to 50 percent correla-
tion to the S&P 500 index) so they might be a good choice for an investor
seeking to diversify a traditional stock portfolio. Many sector funds are
concentrated in technology stocks, so they would not be as effective in di-
versifying a technology-heavy portfolio.
Fixed Income Hedge Funds
Fixed income strategies include the hedged strategies that invest in bonds
and other fixed income instruments. Fixed income strategies include fixed
income arbitrage, mortgage funds, various default-risk funds, and emerg-
ing markets debt funds.
Fixed Income Arbitrage
Fixed income arbitrage funds rely primarily on
debt instruments. Sometimes the group is called just "fixed income fund"
to recognize that some of these funds retain substantial risks, albeit typi-
26
HEDGE FUND COURSE
ccc_mccrary_ch02_19-34.qxd 10/6/04 1:41 PM Page 26