Types of Hedge Funds

gage securities except that they involved other debt instruments, usually
moderately low to low grade corporate bonds. Hedge funds use these in-
struments--including collateralized loan obligations (CLOs) and collater-
alized bond obligations (CBOs)--to earn credit spread without taking
substantial interest rate risk, to arbitrage against other credit default in-
struments, or as a way of financing positions.
The MBS and CDO funds are often included in the fixed income cate-
gory of hedge funds. Like the other fixed income funds, these funds have
had lower average returns and lower volatility of returns than most hedge
fund strategies. Investors have become nervous about holding MBS hedge
funds after the losses at Granite fund and other mortgage funds, which
probably explains why this sector remains small.
Credit, Bankruptcy, and Distress
This category of hedge fund is listed
with other fixed income strategies. But while these funds tend to invest in
debt instruments of financially troubled companies, the category is broad
enough to include equity investments.
Generally, hedge funds buy and hold debt instruments of companies in
or near default. Hedge funds may sell short securities of some companies.
The managers may create hedges, buying one security and selling short
other issues of the same company (hedging debt by selling common, for ex-
ample) or instruments of other companies. The hedge fund may also hedge
a portfolio of instruments with credit derivatives.
Most of the data vendors track a distress category of hedge funds. Per-
formance has been fairly high on distress hedge funds, with low to moder-
ately low risk. In general, these funds tend to do best when stock returns
are positive. There is a moderate tendency for these funds to do well when
rates rise. These funds also do well when securities markets are calm. For
example, most indexes of bankruptcy and distress strategies are negatively
correlated with the VIX index of stock option volatility (when volatility
declines, these funds do well).
Emerging Markets
As the name of the category suggests, emerging mar-
kets hedge funds invest in securities issued by companies or countries that
don't have well-established securities markets. These investments can be ei-
ther debt or equity investments. Hedge funds may acquire a widely diversi-
fied portfolio of instruments from many countries or may focus on a
particular country or economic region.
Generally, these funds cannot or do not hedge the risk in these portfo-
lios, either because there is no futures or derivatives market for hedging or
because the fund manager wants to retain the market exposure. Because
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