Types of Hedge Funds

cally not the risk of rising or declining rates. The funds combine long and
short positions with derivative instruments to hedge the level of interest
rates, the rates of one maturity sector versus other maturity sectors (the
"yield curve"), credit risks, and other factors.
Fixed income arbitrage funds have very effective hedges because inter-
est rates tend to move up and down together (to a lesser extent when
hedges span international borders or involve significantly different default
risks). Because these hedges remove much of the day-to-day portfolio risks,
arbitrage funds or "arb" funds usually have the highest leverage of all
hedge fund strategies.
Fixed income arb funds may have sizable positions in foreign cur-
rencies but the currency exposure is usually hedged away. Similarly, the
funds frequently buy individual issues that have considerable interest
rate risk. However, this category of hedge fund would hedge away most
of this risk.
As a group, fixed income funds have produced the lowest returns over
time. However, the returns are rather consistent over time and the funds
have low volatility of returns. The performance is nearly independent of
stock and bond returns. Fixed income funds are viewed as more risky than
the historical data would suggest because several fixed income funds have
failed and created a major impact on the markets. For example, both the
Granite Fund and Long-Term Capital Management lost nearly 100 percent
of their capital while investing primarily in fixed income assets. Each of
these highly publicized failures was accompanied with dislocations in the
fixed income markets.
Mortgage-Backed and Collateralized Debt Obligations
Mortgage-backed se-
curities (MBSs) include a variety of bonds backed by mortgage loans. Most
mortgage loans (especially residential loans) can be repaid with little or no
penalty at any time. This right closely resembles an option because the
homeowner can refinance if rates decline but force a lender to hold to a
fixed rate if rates rise.
When borrowers repay these mortgage loans, investors must reinvest,
often at a lower rate. A variety of engineered securities--collateralized
mortgage obligations (CMOs), real estate mortgage investment conduits
(REMICs), and interest-only (IO) and principal-only (PO) notes--divide
the many risks of the underlying loans in ways that may be more attractive
to most investors. As it works out, much of the option risk gets distilled
into a couple of high-yield, high-risk assets. Usually MBS strategies con-
centrate on buying this tricky category and hedging the many risks present
in the investment.
Collateralized debt obligations (CDOs) resemble the engineered mort-
Types of Hedge Funds
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