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Compare the major hedge fund approaches built on equities or on macro views, and explain what returns and risks each one typically carries.

FRM® Part II · Risk Management and Investment Management · Hedge Fund Investment Strategies · FRM2.IM.8.a

The idea

Equity and macro hedge funds differ in what they bet on and how much market risk they keep. Long/short equity funds hold longs and shorts and earn from stock selection plus whatever net market exposure they choose to keep. Equity market neutral funds size positions so net beta, and often sector and factor exposure, is close to zero. Their return is a modest long-minus-short spread that leverage must scale up. Dedicated short bias funds run negative beta and lose when markets rise. Global macro funds take discretionary directional positions in currencies, rates, commodities and equity indices, usually with leverage. Managed futures funds follow trends systematically, gaining in sustained moves and losing in whipsaw markets. Common traps are treating dollar neutral as beta neutral and overlooking crowded factor exposure and leverage. Exam point: match each approach to its characteristic return source and its main risk.

Formulas

Net market beta of a long/short fund relative to capital

net beta = (L × βL − S × βS) ÷ capital

L
the value of long positions
βL
the average beta of the longs
S
the value of short positions
βS
the average beta of the shorts
capital
the fund's capital

Subtract the short side and divide by capital, not gross exposure. Dollar net exposure ignores the betas.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits an equity market neutral hedge fund?

  1. It stays fully invested in long-only stock positions and uses index futures to raise its net exposure to the equity market.Why not: Describes a leveraged long-only fund; market neutral funds do not hold net market exposure.
  2. It keeps a net short position in the equity market so that it profits when broad stock prices fall.Why not: Confuses market neutral with dedicated short bias, which deliberately runs negative beta.
  3. It holds longs and shorts sized so net market exposure is near zero, earning the spread between its longs and shorts. - correct
  4. It takes concentrated directional views on currencies and interest rates, based on macroeconomic forecasts.Why not: Describes global macro, which bets on macro variables rather than on stock spreads.

Equity market neutral funds balance longs and shorts so that beta (and often sector exposure) is near zero. Return comes from stock selection, the long-minus-short spread, rather than market direction.

A harder one

A dedicated short bias fund has a market beta of -0.8 and generates stock-selection alpha of 2% a year. The risk-free rate is 3% and the equity market returns 15% over the year. Using the CAPM relationship, closest to which fund return is expected?

  1. -7.0%Why not: Applies beta to the full market return rather than the excess return over the risk-free rate.
  2. -4.6% - correct
  3. -6.6%Why not: Omits the 2% alpha from the stock-selection skill.
  4. 14.6%Why not: Treats beta as +0.8; a short bias fund has negative market exposure and loses when the market rises.

Return = Rf + beta x (Rm - Rf) + alpha = 3 + (-0.8)(12) + 2 = -4.6%. A short bias fund can lose money in a strong bull market even with positive alpha.

The hardest tier

Over one week many quantitative equity market neutral funds, each beta neutral and well diversified by sector, suffer large losses together while the broad index barely moves. Which explanation best accounts for the losses?

  1. A sharp fall in the equity market hurt the funds because their net long exposure was very large.Why not: Contradicts the setting: the funds are beta neutral and the index barely moved.
  2. The funds' short positions were wrong because short bias funds always lose in rising equity markets.Why not: Applies a short-bias profile to a market neutral fund and ignores that the index was flat.
  3. Many funds held similar factor positions, so forced deleveraging by some moved prices against all. - correct
  4. Interest rate risk dominated because market neutral funds are mainly long duration bond positions.Why not: Confuses equity market neutral with fixed income strategies; the funds hold stocks, not duration.

Beta neutrality does not remove factor and crowding risk. When similar quant models hold the same longs and shorts, forced selling by some pushes the shared positions against all, and leverage magnifies the loss.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

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