Relative Value Arbitrage strategies rely on identifying inefficiencies in the market that produce differences in the prices of equities, fixed interest securities and derivatives of the same or related company. They are designed to make profits in either a rising or falling market:

Convertible Arbitrage Strategy, where convertible bonds and preference shares are compared to the company's underlying equity, converting some of the convertible securities when an arbitrage opportunity presents itself.

Fixed Income Arbitrage Strategy, where arbitrage opportunities are sought in bonds and interest related derivatives traded on various global markets.

Equity Market Neutral Strategy, dealing mainly in shares looking for value opportunities while simultaneously working to hedge against directional market risk, this is the original class of hedge fund, using short selling as well as buying.

Event Driven Arbitrage strategies seek to profit from analysis of unusual situations, such as mergers, restructures or changed in leadership:

Merger Arbitrage Strategy, sometimes called risk arbitrage. When a company announces that they are going to buy another company with their own stock they will announce a ratio, for example Tiger Shark Ltd they will buy all one million shares of Sardine Ltd with half a million shares of its own. Merger arbitrage specialists will then watch the share prices closely and buy whichever one is cheap compared to the ratio. Alternatively they may name a dollar price for each share they will buy, arbitrageurs will then have to assess the likelihood of the merger going ahead and thus will have some idea of whether or not the stock as it trades today is fairly priced.

Distressed Securities Strategy, this is an extreme form of value or contrarian investment, buying bonds and equity in companies widely thought to be on the verge of collapse. Even the most miserable companies can have some value on the chopping block and if investors flee in panic the market may price the securities below liquidation value.

Opportunistic and Directional funds are less concerned with arbitrage strategies that make money in a rising or falling market, these funds actually try to predict a rising and falling market and trade accordingly:

Equity Long Short Strategy, this is basically just an ordinary managed share fund but the manager has a lot more discretion to act on their instincts and forecasts than most conventional managers. They have no limitation on their ability to short sell the market if they want to. Rather than try to keep market direction out of the equation by balancing long and short positions, they may become aggressively short at times when they anticipate market drops.

Macro Strategy, this is the most famous type of hedge fund today. A fund where analysts look at whole countries from a top-down perspective and speculate on currencies, stock indexes and bond markets. Sometimes they may use huge leverage to magnify returns. It is these leveraged macro funds that make the headlines with their incomprehensibly large profits and losses.

Decorrelation Strategy, this is a strategy that even more than the others probably depends on the skill of the traders operating it or the power of their models. They are traders in futures and options, they may use option decay techniques or they may be trend followers. This is "rocket science" type stuff, where sophisticated quantitative computer models ("black boxes") tell the traders what to buy and sell.

Emerging Markets Strategy, this is a type of fund that specialises in investing in under-researched emerging markets seeking undervalued securities or arbitrage opportunities created by market inefficiency or market immaturity.

Other hedge funds set out with a quantitative goal, and irrespective of returns seek out success in meeting that goal. Just as the measure of an index fund is how well it tracks an index, some of these other quantitative funds have goals such as replication of indexes, but in a different manner. For example a fund might have the goal to match the performance of the Nasdaq index in reverse, this is to say they will short sell every Nasdaq 100 stock to achieve returns exactly opposite what the Nasdaq did.

Not surprisingly, a negative Nasdaq fund would have been one of the top performing funds in America during the "tech wreck". Others track it with positive correlation, trying to achieve double the performance. This is actually extremely difficult to do and brings up a variety of difficult technical challenges.

These sorts of hedge funds remind me of more traditional theme funds. You buy a health care fund to invest only in health care stocks, not caring about opportunities outside that sector. These correlation funds aren’t trying to achieve high performance, just trying to achieve a correlation. If you are bullish or bearish on an index you can go into one of these funds instead of using futures or options and achieve a multiple of the performance you would normally get with a long or short position.

Some hedge funds use many techniques, they employ a couple of dozen traders and a risk manager as foreman, and have each of them trading their account for profit. They may be enormously leveraged, using either vast amounts of borrowed money or accessing this leverage through generous margin requirements for professional futures traders.

Not all have this leverage, in fact there are hedge funds out there that aren’t leveraged at all, but nevertheless the whole idea of the very leveraged hedge fund seems to stick in people’s minds and when most people think of a hedge fund they think of the Long Term Capital Management (LTCM) fund.

LTCM was run by a bunch of Nobel Prize winning geniuses, including the ones behind the Black-Scholes option pricing model, LTCM went really well for a year or two, making unprecedented profits, then Russia defaulted on its debts and the fund got stuck in some illiquid positions, losing a few trillion dollars.

Although LTCM is not typical of many hedge funds, it is probably the sort of thing that comes to mind for most people when they hear about these things. LTCM is the ultimate act of untruth in labeling, as they were basically a giant financial vacuum cleaner sucking up pennies from all over the world by finding mispriced options and arbitrage opportunities using a tricked up version of the Black-Scholes option pricing model (actually, nobody really knows for sure what LTCM was up to, the techniques are still a closely held secret). They were primarily engaged in very short term options trading and were about as different to a genuine long term buy and hold investor as it is possible to be.