Types of Hedge Funds: Absolute-Return and Directional

You can sort hedge funds into two basic categories: absolute-return funds and directional funds. The hedge fund that you choose depends on your investment strategy.

Absolute-return hedge funds as investments

Sometimes called a “non-directional fund,” an absolute-return fund is designed to generate a steady return no matter what the market is doing.

Although absolute-return funds are close to the true spirit of the original hedge fund, some consultants and fund managers prefer to stick with the label absolute-return fund rather than “hedge fund.” The thought is that hedge funds are too wild and aggressive, and absolute-return funds are designed to be slow and steady. In truth, the label is just a matter of personal preference.

An absolute-return strategy is most appropriate for a conservative investor who wants low risk and is willing to give up some return in exchange. Hedge fund managers can use many different investment tools within an absolute-return strategy.

Investing in directional hedge funds

Directional funds are hedge funds that don’t hedge — at least not fully. Managers of directional funds maintain some exposure to the market, but they try to get higher-than-expected returns for the amount of risk that they take.

Because directional funds maintain some exposure to the stock market, they’re said to have a stock-like return. A fund’s returns may not be steady from year to year, but they’re likely to be higher over the long run than the returns on an absolute-return fund.

Directional funds are the glamorous funds that grab headlines for posting double or triple returns compared to those of the stock market. The fund managers may not do much hedging, but they have the numbers that get potential investors excited about hedge funds.

A directional strategy is most appropriate for aggressive investors willing to take some risk in exchange for potentially higher returns.

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