Hedge Fund Investing Chapter 1 Part 2: Strategies, Leverage, and Performance

In Part 1 we covered what alternative investments are and how hedge funds are structured. Now we get into the fun stuff. How do hedge funds actually make money? What strategies do they use? And how does leverage turn a 10% market gain into a 23% return?

The Five Main Hedge Fund Strategy Types

Mirabile breaks hedge fund strategies into five broad categories. Every fund fits somewhere in here, though the boundaries aren’t always clean.

1. Macro - These funds bet on big-picture stuff. They go long and short across multiple asset classes (stocks, bonds, currencies, commodities) using a wide range of instruments. Some managers rely on their own judgment (discretionary), others follow systematic trend models. Think George Soros betting against the British pound. That’s macro.

2. Equity Hedge - Long and short stock strategies. A fund might buy IBM because they think it’s undervalued and short Microsoft because they think it’s overpriced. If the whole tech sector drops, the short offsets the long. The fund profits from relative performance between the two stocks, not from overall market direction.

3. Relative Value - Arbitrage strategies. These funds look for small pricing differences between similar securities that should converge. Fixed income, credit, and convertible bond arbitrage all fall here.

4. Event Driven - Betting on corporate events. Mergers, bankruptcies, spin-offs, patent approvals. Risk arbitrage (buying the target company and shorting the acquirer in a merger) is a classic example. Distressed investing also belongs here.

5. Multistrategy - Funds that mix and match across all the above categories. They allocate capital dynamically depending on where the best opportunities are. Many funds of hedge funds also fit this description.

One note from Mirabile: there is no industry-wide agreement on how to classify sub-strategies. Different data providers use slightly different systems. As long as you’re consistent in how you compare funds, you’re fine.

The “2 and 20” Fee Structure

Before we get to leverage, let’s talk about how managers get paid. The classic hedge fund deal is called “2 and 20”: a 2% annual management fee plus 20% of the profits.

Mirabile walks through a clear example. Take a fund with $100 million in assets:

• Trading profit: $20 million
• Net dividends, interest, and borrowing costs: -$5 million
• Administrative costs (0.5%): -$500,000
• Management fee (2%): -$2 million
• That leaves $12.5 million before performance fees
• Performance fee (20% of $12.5M): -$2.5 million
• Net return to investors: $10 million (10%)
• Manager keeps: $4.5 million (about 31% of gross returns)

So the investor gets 69 cents out of every dollar of gross profit. The manager takes 31 cents. That’s a significant cut.

Two important protections exist for investors. A high-water mark means if the fund loses money one year, the manager doesn’t collect performance fees until they’ve made back the loss first. A hurdle rate is a minimum return the fund must hit before the performance fee kicks in.

How Leverage Actually Works

This is the part that makes hedge funds different from your regular index fund. Leverage means buying or selling more than the money you actually have by borrowing from banks, brokers, or using derivatives.

Leveraged long position example: A fund raises $50 million from investors and buys $100 million worth of stocks. It borrows the other $50 million from a broker. If those stocks go up 10%, the fund makes $10 million in trading profit. Add $1.5 million in net positive carry (dividends of $4M minus borrowing costs of $2.5M). Total return on the $50 million invested: 23%.

Without leverage, the same 10% gain plus 4% dividends would give you 14%. Leverage added 9 percentage points.

But leverage cuts both ways. If the portfolio drops 10%, the loss is $10 million, reduced slightly by the $1.5 million positive carry. That’s -17% on a $50 million fund. Without leverage, you’d only be down 6%. Leverage added 11 percentage points of extra loss.

Leveraged short position example: A fund raises $50 million and shorts $100 million worth of stocks. If those stocks drop 10%, the fund makes $10 million. Add $4 million in net financing income (interest on the cash balance minus dividends owed and borrow fees). Return on investment: 28%.

Short selling generates cash because when you sell borrowed shares, the cash sits in your account earning interest.

The real power comes from combining long and short positions. Most funds do both at once. Overall market moves cancel out and the fund captures the relative difference between its picks. Leverage magnifies those relative gains while short selling reduces portfolio volatility.

Reporting Monthly Returns

Hedge funds report results to investors monthly, net of all fees. The components of a fund’s return break down like this:

• Trading profit or loss from buying and selling securities
• Interest income or expense from borrowing or lending cash
• Dividends and coupons received on long positions (or paid on short positions)
• Borrow fees for renting shares to sell short
• Cost of carry which is the net of all the above financing items
• Management and performance fees deducted from gross returns

Different strategies have different return profiles. A relative value fund should show big interest numbers. A distressed fund should have high coupon income. A global macro fund using futures should generate interest income but not pay any. If the numbers don’t match the strategy, that’s a red flag.

Measuring Performance and Risk

Funds report several key metrics to investors:

Average returns can be arithmetic mean (simple average) or geometric mean (compound growth rate). The geometric mean is more accurate for measuring actual growth and is the one funds should use when reporting.

Standard deviation measures how volatile returns are. Higher standard deviation means more unpredictable results.

Skew tells you whether surprises tend to be positive or negative. Negative skew means nasty downside surprises. That’s bad.

Kurtosis measures how fat the tails of the return distribution are. Kurtosis above 3 means more extreme outcomes than a normal distribution would predict. Also bad.

Funds also report risk ratios like the Sharpe ratio (return per unit of risk), maximum drawdown (worst peak-to-trough loss), and Sortino ratio (like Sharpe but only counts downside volatility).

Gross and Net Exposure

Funds report their market exposure as a percentage of assets under management. Two key numbers:

• Gross exposure = long market value + short market value. This tells you the total amount of assets exposed to price changes.
• Net exposure = long market value - short market value. This tells you the directional tilt.

A fund with $100M long and $50M short has 150% gross exposure and 50% net exposure. But raw market values can be misleading. That’s why many funds also report beta-adjusted exposure, which accounts for how sensitive each position is to market moves.

For example, if your $100M longs have a beta of 0.5 and your $50M shorts have a beta of 1.0, your beta-adjusted net exposure is actually zero. The fund would show almost no correlation with the S&P 500.

Some funds also report Value at Risk (VAR), which estimates the maximum expected loss over a given period. Especially useful for global macro funds with diversified exposure.

That wraps up Chapter 1. The key takeaway: hedge funds combine traditional investing with leverage, short selling, and derivatives to create outcomes that look nothing like a regular portfolio. Whether those outcomes are good or bad depends on the skill of the manager and the strategy they’re running.

Previous: Chapter 1 Part 1 | Next: Chapter 2 Part 1

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.