Discretionary Hedge Fund Strategies

Sophisticated investors helped catapult the industry as many were looking for investment alternatives that were not correlated to the stock market.

As asset allocation came into prominence in the mid-1990’s hedge funds grew in popularity and so did their strategies which encompass a broad range of concepts ranging from discretionary models to quantitative trading strategies.  This article will discuss the most popular hedge fund strategy that is discretionary known as global macro.

Global Macro

A global macro hedge fund employs a strategy that focuses on economic and monetary policy changes that will create directional changes in equity indexes, interest rates, currencies and commodities.

A global macro strategy is generally considered a discretionary strategy where a manager will use a number of different tools to form an investment thesis.  For example, a global macro manager might use US growth prospects to take a position where he believe US interest rates will increase at a quicker pace than is currently implied in the market.

Currencies

Currency strategies generally focus on the relative strength of one currency versus another. A currency is usually quoted as an exchange rate in the form of a currency pair.  A currency pair is one countries currency relative to another countries currency.

Currency traders follow trends within the global economic environment as well as monetary policy.  Traders will focus on the interest rate differential which is the difference between one country’s interest rates and another country’s interest rates.   The most liquid currency pairs are the major currency pairs which include the US dollar as part of the security that is traded.  Cross currency pairs are those that do not include the dollar and emerging market currency pairs are those that come from developing countries.

One major advantage a strategy that is focused on currencies is the leverage that is employed within the currency markets.  It is not uncommon for a currency trader to find leverage that is 200 to 1, which allow a manger to enhance his returns, while taking significant risks.

Interest Rate Trading

Portfolio managers who actively trade interest rates within the context of a global macro strategy usually invest in sovereign debt instruments.   This includes US Treasury instruments, Japanese debt instruments and European debt instruments. The majority of these types of instruments are traded in either the ETF space, the derivative space or with cash bonds.  Leverage within the debt markets is substantial allowing investors to enhance returns while assuming risk. Strategies include outright directional risk, calendar spread risk and inter-market spreads.

Stock Index Trading

Equity Index investment managers use equity indexes to speculate on the direction of global bourses with a view toward growth or contraction. In general, index strategies are directional, but some manager’s trade spreads.  For example, a manager might consider trading the S&P 500 versus the Nasdaq or an intra-country spread such as a US bourse versus a German bourse.

Summary

Hedge funds use a plethora of investment strategies to generate returns for clients.  They are generally categorized as discretionary or quantitative.  This article focused on the most popular discretionary strategy in which portfolio managers use their years of experience and knowledge of the markets to generate returns.