A directional hedge fund is a hedge fund that doesn’t hedge, whether partially or fully. A directional fund maintains some exposure to the market without placing much emphasis on hedging risk. Unhedged risk makes directional funds less steady as their primary aim rests on generating higher returns. Fund managers focus on making higher-than-expected returns for a given amount of risk. A fund’s returns may fluctuate from year to year, but they tend to be higher over the long run than the returns on a non-directional fund. The performance of a directional fund may experience very wide swings, producing large returns some years and meager returns in other years. As long as the performance trend is upward, directional funds particularly suit long-term investors. They are also attractive to aggressive investors who look for investments that outperform the market indices (i.e., investments with above average returns). With double or triple-digit returns in mind, fund managers usually apply leveraging techniques to amplify the returns.
A non-directional hedge fund (absolute return fund) is a hedge fund that aims to generate a stable return regardless of market performance. In other words, it is designed to deliver positive returns in all market conditions, with low volatility. In essence, fund managers need to get rid of all market risk in order to isolate their funds from market fluctuations. If the market risk is neutralized, the fund performance would depend solely on the manager’s skill (i.e., alpha factor). This type of fund particularly addresses the needs of conservative investors who are typically concerned with risk reduction even if they would sacrifice some return. Like fixed-income instruments, non-directional funds generate fixed income, i.e., relatively steady but relatively low returns. A typical income target of these funds ranges between 8 and 10 percent (it is usually above the long-term rate of return on bonds and below the long-term rate of return on stocks).
The following table summarizes the main differences between directional hedge funds and non-directional hedge funds:
| Directional hedge fund | Non-directional hedge fund | |
|---|---|---|
| Returns | Above average | Average or below average |
| Type of returns | Stock-like (beta-derived) | Bond-like (alpha-derived) |
| Risk/volatility | High | Low |
| Correlation with market | High | Low or nil |
| Type of investors | – Aggressive investors – Long-term investors | – Conservative investors – Risk-averse investors |
| Techniques used | Leverage | Hedging |
