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CAIA Level I · Topic guide

Hedge Funds: Strategies and Exposures

Hedge funds use strategies such as long/short equity, event-driven investing, relative value and macro trading. Identify the return driver, then inspect leverage, concentration, financing and exit terms. The word hedge does not promise low risk.

The key decisions, at a glance

  • 1. Long/short equity

    Separate gross exposure from net directional exposure.

    Watch for: Low net exposure does not remove stock-selection or funding risk.

  • 2. Event driven

    Returns depend on an event such as a merger or restructuring.

    Watch for: A spread can widen sharply if the event fails.

  • 3. Relative value

    A position trades a relationship between related instruments.

    Watch for: Small spreads may be supported by large leverage.

  • 4. Macro

    Positions express views on rates, currencies or markets.

    Watch for: Different instruments may still express the same macro view.

Original worked case

A 60% net fund can have 180% gross exposure

Given: A fund with $100m NAV has $120m of long positions and $60m of short positions. Longs fall 10% and shorts rise 5%. Ignore fees, financing and trading.

  1. 01 Measure exposures

    Gross = 120% + 60% = 180%; net = 120% - 60% = 60%.

  2. 02 Long-side loss

    $120m × -10% = -$12m.

  3. 03 Short-side loss

    A 5% rise costs $60m × 5% = $3m.

Answer and interpretation

Total loss is $15m, or 15% of opening NAV. A modest net exposure did not protect the fund from adverse moves on both sides.

Change one assumption

If the shorts fall 5% instead, they gain $3m and the net loss becomes $9m.

Independent teaching example with the stated assumptions. Not an official exam question, marking key or observed market trend.

Understand the method

Part 1

Equity long-short combines stock selection with exposure choices

A long position benefits when its price rises; a short position benefits when its price falls, subject to borrowing and trading costs. Net exposure subtracts short market value from long market value relative to capital. Gross exposure adds their absolute amounts. A fund that is 120% long and 80% short has 40% net and 200% gross exposure, before derivative adjustments.

Low net exposure does not imply low risk. Long and short holdings can have different market betas, sector concentrations or sensitivities to crowded factors. Short positions can face recalls, rising borrow costs and losses without the same fixed upper bound as a fully paid long position. Evaluate beta and scenario exposures alongside the simple capital ratios.

Part 2

Event-driven returns depend on the event actually occurring

Merger arbitrage often seeks to earn the spread between a target’s trading price and the consideration expected at completion. That spread compensates for deal failure, delay, financing, regulatory and other risks. An attractive annualized spread can conceal a highly asymmetric outcome: a modest gain if the transaction closes and a much larger loss if it fails.

Distressed and restructuring strategies focus on claims whose values depend on negotiations and reorganizations. Priority, collateral and enterprise value matter, but the timing and terms of a settlement also affect return. Avoid treating an anticipated catalyst as a certainty. Define the event, the alternative outcome and the capital required while waiting.

Part 3

Relative value still carries financing and convergence risk

Relative-value trades buy one exposure and sell another based on a pricing relationship. Examples can involve related bonds, a convertible and its equity hedge, or different points on a yield curve. The desired outcome is convergence, but a spread can widen before it narrows. A hedged market exposure therefore does not eliminate the need for margin, funding and reliable execution.

Leverage makes small spreads economically meaningful and can also force a close before convergence. Ask whether a hedge remains effective in stressed markets, whether both legs are equally liquid and whether financing terms can change. A trade can be right about long-run value and still lose because the investor cannot survive the path.

Part 4

Macro and managed futures express views in different ways

Macro strategies can take positions across rates, currencies, equities and commodities based on economic or policy views. Managed-futures strategies often use systematic rules on liquid futures, although they are not all identical and are not all trend-following. A trend system can benefit from persistent directional moves while suffering repeated small losses when markets reverse frequently.

The implementation matters as much as the label. Position sizing, volatility targeting, collateral, concentration and execution determine the actual portfolio. Evaluate fees and redemption restrictions after understanding the strategy’s liquidity. Investor.gov notes that hedge funds may restrict withdrawals; a fund offering favourable access still needs assets and financing capable of supporting those terms.

Strategy family, return source and stress

Equity long-short

Proposed return source
Security selection and chosen market exposure
Stress scenario
Crowded long and short positions move against the fund

Event-driven

Proposed return source
Completion or restructuring outcome
Stress scenario
Deal breaks or recovery disappoints

Relative value

Proposed return source
Pricing relationship converges
Stress scenario
Spread widens while margin rises

Macro / managed futures

Proposed return source
Directional views or systematic signals
Stress scenario
Rapid reversals or correlated position losses

More worked practice

Original teaching cases. Use the stated assumptions; these are not official exam questions or marking keys.

A merger spread with an asymmetric downside

Given: A target trades at $48. The deal pays $50 if completed; the assumed break price is $35. Use an illustrative 90% completion probability and ignore time, costs and financing.

  1. 1Completion gain is $2 per share; break loss is $13.
  2. 2Expected terminal price under the stated probabilities is 0.90 × 50 + 0.10 × 35 = $48.50.
  3. 3Expected gain is $0.50, about 1.04% of $48, before costs.

Interpretation: The visible $2 spread is not the probability-weighted expected gain. Changing completion probability or the break price can reverse the conclusion.

Check your understanding

Answer first, then open the explanation. These checks are original practice and do not generate an exam score.

1. A fund has zero net exposure. Is it market neutral?

Not necessarily. Different betas, sectors and derivative exposures can leave material market sensitivity.

2. Why is a converging trade vulnerable to funding?

Interim losses and higher margin can force liquidation before convergence occurs.

3. Can a strategy’s historical low volatility establish a safe redemption promise?

No. Redemption capacity depends on asset liquidity, financing and investor flows under stress, not just historical return variation.

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Common questions

Is market neutral risk free?

No. Neutrality to one factor leaves other risks, including stock selection, factor mismatch, leverage and liquidity.

Can net exposure exceed 100%?

Yes. A leveraged portfolio can have net long or short exposure beyond its NAV. Interpret the measure with position sensitivities and financing terms.

Sources and scope

The sources below establish their stated framework or subject context. Calculations and cases are our own teaching material; these sources do not endorse them or establish complete exam coverage.

By MiloPrep editorial team. Updated 10 October 2026. Independent study notes, not affiliated with or endorsed by CAIA Association. How we prepare our content.

Notes

  • * Study scope: Selected study concepts, not complete curriculum coverage. Match your sitting to the official exam-year materials; CAIA’s current resource page now links to 2027. ↩ Return to content