Hedge funds have thrived on their ability to focus on a particular investment niche. Exploiting mispriced assets has allowed hedge funds to generate significant sources of alpha, or excess return, for their clients. But this out-performance does not come free; management fees average 2% plus 20% of the profits (known as the 2 and 20 model). Let's take a look at the the most common strategies employed today.
Convertible Arbitrage: This exotic-sounding name involves buying undervalued convertible bonds (or preferred stock, or warrants) and shorting the underlying stock to create a hedge. The strategy pays off when the value of the convertible bond increases, earning interest on the short-sale proceeds, and/or a further decline in the stock price. Note that this only works when there is a mispricing in the underlying convertible bond and the stock.
Distressed Securities (AKA Vulture Funds): Can be equity or debt securities. A "distressed" company is one that is in or very near bankruptcy. Investing in them requires rigorous analysis on their financial condition to determine if the company can turn itself around. There is potential for a high return. But of course the risks are commensurate with the potential reward.
Emerging Markets: Long-only funds that invest in emerging markets. Shorting and use of derivatives is not available since emerging market countries lack the market depth that developed markets have.
Equity Market Neutral: These funds exploit price discrepancies with combinations of long and short positions. For example an equity market neutral strategy combines a long undervalued position and short overvalued position, which eliminates most of the market risk (but not all).
Fixed Income Arbitrage: Take long and short positions in fixed-income instruments based on expectations of changes in the yield curve and/or credit spreads.
Fund of Funds (FOF): A hedge fund that invests in other hedge funds. They can typically invest in 10-30 different hedge funds with differing investment styles. FOF give investors diversification in the hedge fund universe but must pay an added layer of fees - one to the underlying hedge funds and one to the FOF.
Global Macro: A multi-faceted strategy that attempts to profit from major market trends in both the financial and non-financial markets. Global macro funds use an array of investment vehicles, such as: traditional stocks and bonds, futures, options, commodities, and currency.
Hedged Equity Strategies (AKA Equity Long-Short): The largest of all hedge fund investment strategies, these funds are similar to equity market neutral funds that take can take long or short positions. However these funds don't attempt to combine offsetting long and short positions to eliminate market risk. There can be net-long or net-short positions in different sectors of the market.
Merger Arbitrage: Also called "deal arbitrage" funds, they attempt to realize value from corporate actions like mergers and acquisitions, spin-offs, takeovers, etc. Typically they buy the stock of the target company and short the stock of the acquiring company.

