Hedge Funds: How They Invest Their $2.4 Trillion War Chest

A well-balanced investment portfolio might contain a mix of stocks, bonds, cash, real estate and what are known in financial circles as “alternative investments.” This last mysterious category includes (among other exotica) 10,000 hedge funds now wielding nearly $2.4 trillion in assets worldwide.

Hedge funds have littered the financial pages and gossip rags for years. But how exactly do they put that massive mountain of capital to work?

Those answers involve complex calculations larded with Greek letters, but you don’t need a Ph.D. from Harvard to grasp the basics.

Broadly speaking, hedge funds employ eight investment strategies (see the chart and definitions below):

                                                              Source: Hedge fund industry estimates.

Long/short (25%): The first hedge fund---founded in 1949 by sociologist and financial scribe Alfred Winslow Jones---was based on the idea that balancing a portfolio of stocks with selective short sales (bets that a stock will fall) would deliver comparable or better returns with less stomach-wrenching volatility. That strategy---sound over the long haul and still the most popular---has come under pressure as the pools of money deepened and more hedge funds piled in. The other challenge: correlation. A long/short strategy only works well if undervalued stocks rise while overvalued ones drop. When the entire market moves in lockstep (as it did in 2011 and part of 2012), these bets sour.

Event Driven (19%): Twenty years ago these funds mainly practiced a form of investing called risk-arbitrage. Example: If a company announced an acquisition, the “arbs” would buy shares of the seller (which would rise), short the buyer's shares (which would fall, temporarily) and capture the spread. Today this group hunts for all sorts of “events” that could move a company’s stock---catalysts like a change in the corner office, a merger with a competitor, the spin-off of a division, looming litigation, a major debt restructuring or even a bankruptcy filing.

Multi-strategy (17%): This gang combines a bunch of strategies, often rolled into a fund of funds---with an added layer of fees for the effort.

Discretionary Macro (11%): This strategy involves betting on the direction of currencies, commodities, interest rates and market indices. Swashbuckling macro investors, including poster child George Soros, use lots of leverage (borrowed money) to juice their returns. They also tend to charge higher fees for their expertise---though last month’s sudden interest-rate reversal left many macro funds with bruised ribs.

Systematic CTA (10%): As the name implies, this group uses computer algorithms (or “black boxes”) to follow market trends among all sorts of assets. (CTA stands for Commodity Trading Advisors.) It’s an effective strategy---but only if prices move in one direction for a sustained period of time. Volatility, like the sort we’ve seen in recent months, can really sting.

Credit (10%): This strategy includes everything from lending to corporations, to trading complex derivatives (financial contracts based on a company’s ability to repay its obligations).

Distressed (6%): These guys have steel stomachs and prey on panic. They buy bonds, receivables and preferred stock of companies in financial straits. It’s risky business, but there are plenty of tasty bargains out there, too.

Equity Market Neutral (2%): Like the “long/short” strategy, this one involves buying some stocks while shorting others. The difference is that an equity-market-neutral fund aims to have an even lower correlation to the overall market. Say you bought five biotechnology stocks while simultaneously shorting five others. Choose wisely, add a little leverage, and you’ll clock decent returns---but you’re essentially protected no matter where the market goes. This strategy works well when prices are gyrating (like now), but lags during a steady, sustained bull run.

Suffice to say each strategy has myriad variations, and each has its day in the sun (and the rain). As an asset class, hedge funds aim to make money every year, as opposed to shining by not losing as much as the overall market. For example, when the S&P 500 fell by half during the dotcom crash in 2000, hedge funds managed to post small positive returns.

But that whole "we-shoot-for-absolute-returns" story wears thin when you trail the overall market for ten years, as hedgies have. Despite their underwhelming performance of late, many still charge an annual fee equal to 2% of assets under management, plus 20% of the profits. (By contrast the Vanguard 500 Index Fund, which simply tracks the S&P 500, costs just .05% of assets a year.) Hedge fund clients won’t starve---each must have a net worth of $1 million or make at least $200,000 a year---but that doesn’t mean they’re happy.

Which strategies will light it up in the months to come? That’s anybody’s guess (even Ben Bernanke's). Hedge fund tides can turn fast and hard. Last year assets flowed out of long/short equity and event-driven funds into global macro and multi-strategy funds; this year, the flows have reversed.

One thing’s for sure, though: Size matters. “The one trend that won’t change any time soon is the preference for large hedge funds,” says Allan Ganly, Head of Hedge Fund Content at UBS ' Prime Brokerage division.

By “large” Ganly means funds with at least $5 billion under management, robust computer systems and sprawling staffs. Reason for the trend: Large institutions, like endowments and pensions funds, are putting more money into alternative investments---and big dogs don’t deal with small fry.

That’s not stopping more aspiring Masters of the Universe from starting their own hedge funds: Since 2010, roughly 250 funds (many with under $10 million in assets) have launched each quarter, while 200 have shuttered, notes Ganly.

Investors should wish those entrepreneurs luck. Without them, hedge funds may be doomed to suffer the tyranny of large denominators---and the middling returns that come with them.

[Good summertime reading: Money Masters Of Our Time, by John Train, illuminates the strategies of marquee investors like Warren Buffett, T. Rowe Price, George Soros and John Templeton. It’s a punchy, sometimes breathless read. At-home investors will kill it faster than the Fed kills a stock rally.]