Tactical Portfolios: Strategies and Tactics for Investing in Hedge Funds and Liquid Alternatives

CHAPTER 1

Hedge Fund Strategies and How They Work

Until recently, most investors maintained a traditional portfolio construction of 60 percent in stocks, 20 to 30 percent in bonds, and the rest in cash. That 60 percent was managed passively, using the buy and hold method, with bets placed only on the long side of the trade. That means that investors' only hope was for equities to go up in perpetuity, which as we all know, never actually happens. Markets correct, outside events force sell offs, companies go bust. This is where alternatives come in, helping some of the biggest players in the market mitigate losses during those tough times.

Another term for hedge funds is absolute return, meaning that hedged strategies are designed in order to provide a return instead of 0% and/or mitigate losses in the event of a market correction. The way this works in practice is, if an individual invests in a mutual fund, that fund will likely return 3 percent a year in a positive market. In a down market, that mutual fund could potentially go to zero return and post losses. This is because mutual funds typically place bets that the market will go up.

Hedge funds, on the other hand, have plans in place for both sides. They'll take the view that the value will go up (going long), and also have insurance bets in place in case the market goes down (going short). Sometimes these bets are made together, other times the manager reacts dynamically to a change in market conditions. In a positive market, ...