The investment strategies followed by hedge funds range from the absolute return strategies that aim to hedge away most market movements to directional strategies that aim to profit from directional bets in one market or another. Before getting into the terminology used to describe narrower types of strategies within the industry, let’s consider strategies in terms of beta and alpha. A pure hedge or absolute return strategy would try to eliminate most of the systematic risk of the market by keeping beta close to zero. The hedge fund would then be judged by whether the manager could produce alpha. A directional strategy would earn part of its return from the market itself.5 The manager would still try to produce additional return from the superiority of the manager’s security selection, so the total return would be enhanced by alpha (much like a long-only mutual fund manager).

How would a hedge fund manage to keep its beta close to zero following an absolute return strategy? To do this, a fund might match each long position in a security with a short position in a second, highly correlated security. Suppose the fund manager is focusing on the stocks of utility companies. The manager knows that utility stocks are likely to rise and fall with the market and to be highly correlated with one another. So if the manager takes a matching long and short position in this industry, the market exposure of the position should be marginal. This matching of long and short ...

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