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Types of Hedge Funds

Speaking very generally, hedge funds can be categorized as directional funds (so-called macro funds and most long/short funds) and absolute-return-oriented or ARO funds (sometimes called nondirectional funds or market-neutral funds). Hedge funds, however, are not truly nondirectional or market neutral.

Most directional macro funds employ few or no hedging strategies, but simply make bets on their specific ideas, whereas long/short funds are mainly similar to long-only managers except that they also sell stocks short, thus reducing (but not eliminating) their exposure to broad market trends. Many hedge funds fall easily into these broad categories, but some do not.

Hedge funds can also be categorized according to the kinds of investment strategies they follow. Following are some of the many examples of strategies a hedge fund might focus on:

Convertible security arbitrage. Many companies issue convertible securities—securities that are convertible into another company security at a stated price. Depending on the characteristics of the company, the price volatility of the securities, the relative price level of the securities, the level of interest rates, and other factors, the two securities will tend to trade in a price relationship with each other that can be ascertained. If the securities are trading outside this range, the difference can sometimes be arbitraged at a profit.

Distressed debt. Most investors are familiar with high-yield bonds—lower-rated ...