Hedge Funds are not conventional investment funds and may use some of the following strategies:
A. Hedging by Selling Short:
Selling shares without owning them, hoping to buy them back at a future date at a lower price in the expectation that their price will drop.
B. Using Arbitrage:
Seeking to exploit pricing inefficiencies between related securities.
C. Trading Options or Derivatives:
Contracts whose values are based on the performance of any underlying financial asset, index or other investment.
D. Using Leverage:
Borrowing to try to enhance returns.
E. Investing in Out-of-Favor or Unrecognized and Undervalued Securities
F. Taking Advantage of the Spread Between the Current Market Price and the Ultimate Purchase Price in Situations such as Mergers or Hostile Takeovers
Some Hedge Funds don't actually hedge against risk or may use high-risk strategies without hedging against risk of loss.
For example, a global macro strategy may speculate on changes in countries economic policies that impact interest rates, which impact all financial instruments, while using lots of leverage.
The returns can be high, but so can the losses, as the leveraged directional investments (which are not hedged) tend to make the largest impact on performance.
Most Hedge Funds hedge against risk in one way or another, making consistency and stability of return, rather than magnitude, their key priority.
Event-driven strategies, for example, such as investing in special situations reduce risk by being uncorrelated to the markets.
Hedge Funds may buy interest-paying bonds or trade claims of companies undergoing reorganization, bankruptcy, or some other corporate restructuring - counting on events specific to a company, rather than more random macro trends, to affect their investment.
Thus, they are generally able to deliver consistent returns with lower risk of loss.
Long/Short equity funds, while dependent on the direction of markets, hedge out some of this market risk through short positions that provide profits in a market downturn to offset losses made by the Long positions.
Market neutral equity funds, which invest equally in Long and Short equity portfolios generally in the same sectors of the market, are not correlated to market movements.
A true Hedge Fund then is an investment vehicle whose key priority is to minimize investment risk in an attempt to deliver profits under all circumstances.
Different Hedge Fund styles are as different from one another as are i.e elephants and crocodiles!
So, too, are global macro funds and convertible bond arbitrage funds and Long/Short equity funds.
Different Hedge Fund strategies vary enormously in terms of their returns, volatility and risk.
Therfore, some hedge funds, which are not correlated to equity markets, are able to deliver consistent returns with extremely low risk of loss, while others may be as, or more volatile, than certain mutual funds.