Can someone explain the main hedge fund strategies — long/short equity, event-driven, and relative value — with concrete examples?

Hedge fund strategies differ in their source of return, risk exposure, and market dependence. Here's a practical breakdown of the three major categories tested on CFA Level II.

1. Long/Short Equity:

Buy undervalued stocks (long) and sell overvalued stocks (short). The net exposure determines how much market risk you take.

Example: Ridgeline Capital is bullish on semiconductor stocks but bearish on legacy hardware. They go:

• Long $10M in Vertex Semiconductor (strong AI chip demand)
• Short $7M in Dalton Hardware (declining PC market)
• Net long exposure: $3M (slight bullish tilt)
• Gross exposure: $17M (total capital at risk)

Return source: Stock selection alpha + net market exposure. The short book provides partial hedge but also generates alpha if the shorts decline.

2. Event-Driven Strategies:

Profit from specific corporate events: mergers, spin-offs, bankruptcies, regulatory changes.

Merger Arbitrage Example: Pinnacle Corp announces acquisition of Lakewood Inc at $45/share. Lakewood trades at $43 (the $2 discount reflects deal completion risk). The hedge fund:

• Buys Lakewood at $43
• If deal closes: earns $2/share (4.7% return over 3-4 months = ~15% annualized)
• If deal breaks: Lakewood may drop to $35 (significant loss)

Distressed Investing Example: Hartfield Industries bonds trade at 30 cents on the dollar during bankruptcy. The fund buys bonds at $0.30, expecting the restructured company to emerge with bonds worth $0.55. Return if correct: 83%.

3. Relative Value:

Exploit pricing discrepancies between related securities. Market-neutral by design — returns come from the spread convergence, not market direction.

Fixed Income Arbitrage Example: A 10-year government bond yields 4.20% while a nearly identical 10-year agency bond yields 4.45%. The 25 bps spread is historically wide (average = 15 bps). The fund:

• Buys the agency bond (cheap)
• Shorts the government bond (rich)
• Profits when the spread narrows toward 15 bps

Convertible Bond Arbitrage: Buy a convertible bond, short the underlying equity. The convertible's embedded option is sometimes underpriced relative to equity options — the fund captures the mispricing.

Strategy Comparison:

Key Risk to Understand:

Relative value strategies typically use high leverage because individual spread movements are small. This means they're vulnerable to liquidity crises — when spreads widen instead of converging, leveraged positions face margin calls, forcing liquidation at the worst time.

Explore hedge fund strategy analysis in our CFA Level II course.