Last week, I said that I would broadly explain hedge funds, but I was distracted by their high costs. I promise to stay on point today.

Hedge funds are pooled investment funds that are less regulated than other types of pooled vehicles like mutual funds and ETFs. They are less regulated because their clients are wealthier, which presumes them to be more sophisticated (I’m not sure that’s true, but that’s the idea).

Hedge fund investors usually need to be ‘accredited,’ which means earning $300,000 for married couples for two years or having a net worth in excess of $1 million outside of their primary residence.

By protecting ‘mom and pop’ investors through accreditation, hedge funds can use more aggressive investing techniques, like using leverage, short-selling, and more concentrated portfolios.

Although private investment pools for wealthy investors date back to the 1920s, the first ‘hedged’ fund was formed in 1949 by Alfred W. Jones, who hedged his portfolio by short-selling stocks, which would allow him to profit from both going long stocks that rise and going short stocks that fall.

Notably, a ‘hedged’ fund like this may or may not have a lot of net market exposure.

The term hedge fund is broader, but there are four or five broad categories of hedge funds (with a million sub-derivations).

Hedged Equity

Hedge equity funds most closely resemble the original concept, where managers try to buy stocks going up and sell short stocks going down. Equity Market Neutral funds don’t have any net market exposure, whereas Long-Short funds typically have some market exposure.

Credit Hedge

Credit funds are similar to hedged equity funds but trade in corporate bonds instead of stocks. They usually invest in junk bonds, go long bonds in improving companies, and sell short bonds that they think will falter.

Event Driven

Event-driven funds invest in specific events, such as mergers or special situations like corporate bankruptcies. Merger arbitrage, a classic event-driven strategy dating back to the 1950s, involves buying stock in a company that another company is purchasing.

Activist Investors are another type of event-driven fund. They buy a large stake in a company, often get one or more seats on the board of directors, and advocate for change that should benefit shareholders. The activist hedge fund Elliot Management pushed the current layoffs at Southwest Airlines.

Relative Value

Relative value funds look for mispricing in the value of similar securities. For example, a global stock like Nestle might issue stock in Switzerland and in other markets around the world (I found 19 variations).

For example, if the Nestle stock in Canada trades at a price that differs substantially from the Swiss or Japanese versions, a relative value trader would buy one, sell another, and profit when the two prices converge.

The same can apply to bonds as well. The 29-year Treasury isn’t as liquid as the 30-year and might trade at a discount, so a relative value trader would buy the 29-year and sell the 30-year.

In both of these examples, the underlying value of the security is very similar. Still, the hedge fund doesn’t have a position tied to the stock or bond market since they are long one security and short another.

Global Macro

When we think of hedge funds, we often think of a swashbuckling hero who knows when to go long gold and sell short Japanese bonds, for example, based on their analysis of global markets. Commodity, currency, and cryptocurrency traders, along with trend-followers, fall into this category.

Conclusion

As noted above, this isn’t a complete list of strategies; it’s meant to show the breadth of the approaches that can all be called ‘hedge funds.’

Many of these strategies are available in mutual fund and ETF formats without the accreditation rules but are often watered-down versions of what you can get in a hedge fund.

In fact, I like some of the mutual funds that exist, but we don’t use them. The rationale for holding hedge fund strategies is diversification because their sources of return aren’t related to the direction of stock and bond markets.

Many investors’ problem is that diversification means that hedge fund strategies do poorly when other markets are doing well, and they wonder, ‘Why am I holding this?’

Additionally, when people hear that these strategies are non-correlated, they interpret that to mean that these make money when stocks fall, but that isn’t always true.

And that’s my issue with these strategies: they’re hard to own, and people bail out at the wrong time, just like they do with stock and bond markets. That’s not a fund or strategy problem, but it’s a problem nonetheless.