Hedge Funds: an alternative investment strategy

Hedge funds are alternative or private investment funds whose primary goal is to seek returns in any type of market by using a variety of strategies and instruments. In fact, according to the definition provided by Spain’s CNMV (National Securities Market Commission), “hedge funds differ from traditional funds in that they are not subject to the same investment restrictions, allowing them to employ more complex and diversified strategies.”

In other words, hedge fund managers have greater operational flexibility to achieve positive returns, even during bearish market phases. This enables them to use more complex financial instruments and strategies, such as swaps, short selling, options, and financial futures. At the same time, they can also use leverage or other sophisticated techniques, including derivatives.

Hedge funds, or alternative investment funds, originated in the 1950s with the goal of taking advantage of opportunities in both rising and falling markets. With that premise and philosophy, they aimed to generate positive returns by using various techniques that were often more complex and carried higher risk.

Their role within an investment portfolio is quite clear: to reduce correlation among different assets in order to diversify risk. Typically, a traditional portfolio is made up of conventional market products, such as fixed income or equities. However, hedge funds generally have little to no correlation with these markets—or at least that’s their objective. As a result, they can provide investors with an added layer of stability and returns that would be difficult to achieve by investing solely in traditional markets.

One of the most recognizable features of hedge funds is their use of short positions to profit from market downturns or declines in specific assets. For this reason, they have historically been associated with “bearish funds.” However, short-selling isn’t their only strategy. The three main hedge fund strategies are as follows: relative value, event-driven and opportunistic.

• Relative value: these strategies aim to capitalize on market inefficiencies through the well-known practice of arbitrage. In fixed-income markets, this can occur when the same bond is priced differently due to technical issues or liquidity gaps. Similar situations can arise with other financial instruments, and hedge funds can take advantage of these discrepancies to generate positive returns. Equity market neutral strategies also fall under this category.
• Event driven: These strategies focus on profiting from extraordinary market events. For example, they may target situations such as corporate takeovers, companies in bankruptcy proceedings, or businesses undergoing major restructurings.
• Opportunistic: this last strategy can sometimes be an extension of the previous ones but tends to focus more on large-cap companies. Hedge funds typically look for opportunities during periods of market volatility. For instance, when a major corporation issues a profit warning—alerting investors that its earnings will fall short of expectations—or suffers a negative impact from an external event, such as a war or the announcement of new tariffs, these funds may step in and take on a larger position.

In addition to these strategies, there are others commonly used in the hedge fund space, such as aggressive growth (which involves taking on high levels of risk), global macro (which bases investment decisions on analysis of global market conditions), managed futures (which rely on futures contracts), and directional trading (an approach focused on predicting future price movements).

On the upside, hedge funds stand out for delivering returns during negative market conditions, sometimes outperforming the overall market average. They also provide greater diversification, help reduce the correlation of an investor’s overall portfolio, and offer exposure to more complex strategies.

However, they also tend to carry higher risks. Hedge funds are generally less liquid, offer lower levels of transparency and regulatory oversight, and often charge higher fees. In addition, their complexity is typically higher. Entry requirements can also make them less accessible to retail investors, as some funds require high minimum investments that may be out of reach for certain individuals.

In general, hedge fund performance depends heavily on the specific strategy each fund follows. That’s why it’s more useful to look at the track record of the most prominent funds worldwide.

Leading the pack is Bridgewater Associates, managed by renowned investor Ray Dalio. Over the past five years, it has posted gains of more than 62%. However, when compared to the S&P 500 index, the American benchmark has delivered higher returns.

Another standout hedge fund is the Medallion Fund, which has been closed to outside investors since 2005 and about which little information is available. What is known is that between 1998 and 2021, it generated an annualized return of 66% before fees and 39%after fees.

Finally, there’s Citadel, run by well-known investor Ken Griffin. In 2024, it gained over 15%, and since early 2023, it has outperformed the S&P 500. In addition to minimum investment requirements—which in recent years have become more flexible and tailored to different investors—these funds also generally require investors to have advanced financial knowledge in order for advisors to recommend them.