As with any specialty, the field of hedge fund management has its own distinct vocabulary. Listed below are frequently used terms you may encounter as you consider alternative investment strategies.
A performance measurement that is irrespective of any market or index performance.
An individual who has made $200,000 a year in income for the past two years and has a reasonable expectation of doing so in the future; or one who, together with a spouse, has an income of $300,000 per year; or one who has net worth of $1 million, excluding home and automobile; or an entity with $5 million in invested assets.
The simultaneous purchase and sale of a security or pair of similar securities to profit from a temporary pricing discrepancy.
Investment returns are measured in basis points. One basis point equals 1/100 of a percent. For example, 75 basis points (bps) equals 0.75%.
Convertible bonds trading well below par value, at or near their investment value.
Bonds that can be converted into a fixed number of shares of the issuing company’s stock. They are hybrid securities with features of both bonds and stocks, and therefore their valuations reflect both types of instruments.
A term from regression analysis that describes the strength of the relationship between a dependent and an independent variable. Strategies are correlated if the returns they provide are similar to one another in similar market environments. In the hedge fund context, returns are often referred to as uncorrelated to traditional equity markets, because hedge fund returns do not rely on market direction or outcomes.
Delta refers to how the price of an option will respond to the movement in the price of the underlying stock. Under normal market conditions, a delta-neutral strategy will ideally not incur losses if the price of the underlying stock moves up or down within a defined range.
The amount of risk an unhedged position faces in the market as compared to the net exposure of positions involving long and short hedged relationships.
A measure of how sensitive a bond’s price is to a shift in interest rates. In general terms:
Duration = (Change in price) / Price Change in interest rates
The manager of a fund-of-funds pools capital from investors and then allocates it to multiple hedge fund managers. By making a single investment in a fund-of-funds, investors obtain access to a number of different hedge funds in which, because of the high minimum investment required by each, they normally could not invest individually.
The number of shares of common stock a manager sells short out of the total number possible.
Any investment that is taken in conjunction with another position in order to reduce directional exposure, such as purchasing a long position and a short position in similar stocks to offset the effect any changes the overall level of the equity market will have on the long position.
High Water Mark
Use of a high water mark requires a manager to attain performance above the highest previous level before earning additional incentive fees (see Incentive Fee). This ensures the investor does not pay for covering the same ground twice because losses must be made up before the manager begins participating in the profits.
The return that must be earned each year before the manager starts participating in the profits (see Incentive Fee). Often, the Treasury bill rate or LIBOR is used.
Incentive (or Performance) Fee
The hedge fund manager’s share in the fund’s profits (i.e., carried interest). Typically, 20% is charged each year in addition to a standard management fee.
The practice of borrowing to add to an investment position when it is expected the return from the position will exceed the cost of the borrowed funds.
In the hedge fund context, liquidity refers to the periods during which investors can redeem their investments and have their money returned from the fund (monthly, quarterly, etc.).
The time an investor must remain invested in the portfolio before his or her investment can be redeemed.
London Interbank Offered Rate (LIBOR)
The London Interbank Offered Rate is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market. It is commonly used as a proxy for the risk-free rate of return.
The management fee is based on a percentage of the assets in the fund, usually 1% or 2% each year. In the hedge fund context, it is usually accompanied by an additional incentive, or performance fee (see Incentive Fee).
Market Neutral Portfolios
Market neutral portfolios consist of approximately equal dollar amounts of offsetting long and short equity positions, so total net exposure is close to zero.
Net Market Exposure
The percentage of the portfolio exposed to market fluctuations because long positions are not matched by equal dollar amounts of short positions. A zero net exposure is referred to as dollar neutrality. In general terms:
Market exposure = Long exposure – Short exposure Capital
A hedge ratio that does not add exposure to up or down markets.
Option Adjusted Spread (OAS)
The spread relative to Treasuries that equates the present value of a series of uncertain cash flows of an instrument to its current market price. It is often used with mortgage backed securities (see Spread).
A qualified purchaser is an individual or family company holding at least $5 million in investments; an entity that owns and invests on a discretionary basis at least $25 million in investments; or an entity (regardless of the amount of such entity’s investments) in which each beneficial owner of the entity is a qualified purchaser.
Refers to an equity position sold short, or “short stock” (see Short Selling).
Short Interest Rebate
In a short-sale transaction, the portion of interest or dividends earned by the owner (lender) of shares that is paid to the short seller (borrower) of the shares.
The practice of borrowing a stock on collateral and immediately selling it on the market with the intention of buying it back later at a lower price after the market corrects itself.
Significant Corporate Events
Major public events, such as mergers, bankruptcies and spin-offs, that have the potential to dramatically change a company’s makeup and, as a result, the valuation of its debt and equity instruments.
The difference between the yields of two comparable or related securities. Spreads are measured in basis points. For example, corporate bonds of comparable maturity and comparable coupon rates will have higher yields than Treasuries to reflect greater default risk, so their yields are often quoted as a spread above the Treasury rate. The more risky the bond issue, the larger the spread.
The measure of average deviation from an expected result. The larger the variation, the riskier the investment. Standard deviation is measured mathematically as the square root of the variance. In the hedge fund context, risk is often defined as volatility, as measured by standard deviation.
Traditional, or Long-Only, Investing
Long-only managers purchase what they perceive to be undervalued securities with the hope that the securities’ value will appreciate in order to achieve a profit.
The ability to review the underlying instruments and positions within a manager’s portfolio.
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