New to the world of hedge fund investing? Here is list of the most common hedge fund terms.
- Absolute Return – the goal is to have a positive return, regardless of market direction. An absolute return strategy is not managed relative to a market index.
- Accredited Investor – wealthy individual or well-capitalized institutions covered under Regulation D of the Securities Act of 1933.
- Alpha – the return to a portfolio over and above that of an appropriate benchmark portfolio (the manager’s “value added”).
- Arbitrage – any strategy that invests long in an asset, and short in a related asset, hoping the prices will converge.
- Attribution – the process of “attributing” returns to their sources. For example, did the returns to a portfolio (over and above some benchmark) come from stock selection, industry/sector over- or under-weighting or factor weighting. Software programs are helpful in reporting an attribution.
- Beta – a measure of systematic (i.e., non-diversifiable) risk. The goal is to quantify how much systematic risk is being taken by the fund manager vis-à-vis different risk factors, so that one can estimate the alpha or value-added on a risk-adjusted basis.
- Correlation – a measure of how strategy returns move with one another, in a range of –1 to +1. A correlation of –1 implies that the strategies move in opposite directions. In constructing a portfolio of hedge funds, one usually wants to combine a number of non-correlated strategies (with decent expected returns) to be well diversified.
- Drawdown – the percentage loss from a fund’s highest value to its lowest, over a particular time frame. A fund’s “maximum drawdown” is often looked at as a measure of potential risk.
- Hurdle Rate – the return where the manager begins to earn incentive fees. If the hurdle rate is 5% and the fund earns 15% for the year, then incentive fees are applied to the 10% difference.
- Leverage – one uses leverage if he borrows money to increase his position in a security. If one uses leverage and makes good investment decisions, leverage can magnify the gain. However, it can also magnify a loss.
- Opportunistic – a general term that describes an aggressive strategy with a goal of making money (as opposed to holding on to the money one already has).
- Pairs Trading – usually refers to a long/short strategy where one stock is bought long, and a similar stock is sold short, often within the same industry. Buying the stock of Home Depot and shorting Lowe’s in an equal amount would be an example.
- Portfolio Simulation – involves testing an investment strategy by “simulating” it with a database and analytic software. Often referred to as “backtesting” a strategy. The simulated returns of the strategy are compared to those of a benchmark over a specific time frame to see if it can beat that benchmark.
- Sharpe Ratio – a measure of risk-adjusted return, computed by dividing a fund’s return over the risk-free rate by the standard deviation of returns. The idea is to understand how much risk was undertaken to generate the alpha.
- Short Rebate – if you borrow stock and then sell it short, you have cash in your account. The short rebate is the interest earned on that cash.
- R-Squared – a measure of how closely a portfolio’s performance varies with the performance of a benchmark, and thus a measure of what portion of its performance can be explained by the performance of the overall market or index. Hedge fund investors want to know how much performance can be explained by market exposure versus manager skill.
- Transportable Alpha – the alpha of one active strategy can be combined with another asset class. For example, an equity market-neutral strategy’s value-added can be “transported” to a fixed income asset class by simply buying a fixed income futures contract. The total return comes from both sources.
- Value at Risk – a technique which uses the statistical analysis of historical market trends and volatilities to estimate the likelihood that a specific portfolio’s losses will exceed a certain amount.
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