Types of Hedge Funds:

Hedge funds are generally classified according to the type of investment strategy they run. Below we review the major types of strategies, but refer members of the class to "Hedge Funds Demystified" for greater detail.

Market Neutral (or Relative Value) Funds

Market neutral funds attempt to produce return series that have no or low correlation with traditional markets such as the US equity or fixed income markets. Market neutral strategies are characterized less by what they invest in than by the nature of the returns. They often are highly quantitative in their portfolio construction process, and market themselves as an investment that can improve the overall risk/return structure of a portfolio of investments. Market neutral funds should not be confused with Long/Short investment strategies (see below). The key feature of market neutral funds are the low correlation between their returns and the traditional asset's.

Event Driven Funds

Event driven funds seek to make profitable investments by investing in a timely manner in securities that are presently affected by particular events. Such events include distressed debt investing, merger arbitrage (sometimes called risk arbitrage) and corporate spin-offs and restructuring.

Long/Short Funds

Funds employing long/short strategies generally invest in equity and fixed income securities taking directional bets on either an individual security, sector or country level. For example, a fund might do pairs trading, and buy stocks that they think will move up and sell stocks they think will move down. Or go long sectors they think will go up and short countries they think will go down. Long/Short strategies are not automatically market neutral. That is, a long/short strategy can have significant correlation with traditional markets, and surprisingly have seen large down turns in exactly the same times as major market downturns. For example, Pension & Investments reported on November 30, 1998:

Many long-short managers, which aim to profit from going long on stellar stocks and selling short equity albatrosses, typically use traditional stock valuation factors such as price-to-earnings and price-to-bok value ratios in their mathematical models to cull the winners from the losers. Unfortunately for them, when the market ran into turbulence in late July and August, investors sought safe haven in some of the largest-but expensive-stocks that these models had rejected as overpriced.

Then, after the Federal Reserve Bank began easing interest rates in late September, investors rushed to buy small-capitalization, high-octane stocks that had been neglected in favor of large cap stocks for most of the year. ... As a result, some market long-short managers got hit with a double-whammy.

Tactical Trading

Quoting from "Hedge Funds Demystified":

Tactical trading refers to strategies that speculate on the direction of market prices of currencies, commodities, equities and/or bonds. Managers typically are either systematic or discretionary. Systematic managers are primarily trend followers who rely on computer models based on technical analysis. Discretionary managers usually take a less quantitative approach and rely on both fundamental and technical analysis. This is the most volatile sector in terms of performance because many managers combine long and/or short positions with leverage to maximize returns...

The Hedge Fund Industry and Quantitative Methods
Quantitative methods have been successfully applied in the hedge fund industry to improve returns, and control risk. That said, there have been striking failures of seemingly quantitatively driven funds (such as Long-Term Capital). Some of the most quantitatively driven strategies occur in the Market Neutral/Relative Value Sector of the Hedge Fund World, so we will exam this sector in more detail by discussing some of the specific types of strategies they employ. The following is a list of important and quantitatively driven market neutral/relative value strategies. I refer you to "Hedge Funds Demystified" for a detailed description of each:

Fixed income arbitrage
Covertible bond arbitrage
Mortgage backed security arbitrage
Derivatives Arbitrage
Market Neutral Long/Short Equity Strategies

Credit should be given to Neil A. Chriss as some of these references are a compilation from a lecture series.