Glossary

Alpha

Measures the value that an investment manager produces, by comparing the manager's performance to that of a risk-free investment (usually a Treasury bill). For example, if a fund had an alpha of 1.0 during a given month, it would have produced a return during that month that was one percentage point higher than the benchmark Treasury. Alpha can also be used as a measure of residual risk, relative to the market in which a fund participates.

Annual rate of return

The compounded gain or loss in a fund's net asset value during a calendar year.

Arbitrage investment strategy

An approach that aims at exploiting price differentials that exist as a result of market inefficiencies. Arbitrage plays typically involve purchasing a security in one market, while selling an instrument with similar performance characteristics in another market -- earning returns that far exceed the risk incurred.

Average annual return (annualized rate of return)

Cumulative gains and losses divided by the number of years of an investment's life, with compounding taken into account. The measure is used to compare returns on investments for periods ranging from partial to multiple years.

Average monthly return

Cumulative gains and losses divided by the number of months of the investment's life, with compounding taken into account.

Average rate of return

The mean average of a fund's returns over a given number of periods. It is calculated by dividing the sum of the rates of return over those periods by the number of periods

Beta

Gauges the risk of a fund by measuring the volatility of its past returns in relation to the returns of a benchmark, such as the S&P 500 index. A fund with a beta of 0.7 has experienced gains and losses that are 70% of the benchmark's changes. A beta of 1.3 means the total return is likely to move up or down 30% more than the index. A fund with a 1.0 beta is expected to move in sync with the index.

Bottom-up investment strategy

An approach that seeks to identify investments that will produce strong returns, before assessing the influence that economic factors will have on those assets

Closed fund

A hedge fund or open-end mutual fund that has at least temporarily stopped accepting capital from investors, usually due to rapid asset growth. Not to be confused with a closed-end fund.

Compounded monthly return

The average monthly increase that, when compounding is taken into account, would have produced a fund's total return over any period of time. For example, if a fund had a one-year return of 20%, its compounded monthly return would be 1.53% -- the amount it would have needed to gain in each of 12 months to achieve that full-year result.

Convertible arbitrage investment strategy

A conservative, market-neutral approach that aims to profit from pricing differences or inefficiencies between the values of convertible bonds and common stock issued by the same company. Managers of such funds generally purchase undervalued convertible bonds and short-sell the same issuers' stock. The approach typically involves a medium-term holding period and results in low volatility.

Correlation (R)

R shows if there is any correlation between the fund and the market. 1.0 is perfect correlation, 0.0 is absolutely no correlation and –1.0 is perfect negative correlation.

Derivative

A financial instrument whose performance is linked to a specific security, index or financial instrument. Typically, derivatives are used to transfer risk or negotiate the future sale or delivery of an investment. Derivative instruments come in four basic forms: forward contracts, futures contracts, swaps and options.

Distressed securities investment strategy

Purchasing deeply discounted securities that were issued by troubled or bankrupt companies. Also, short-selling the stocks of those corporations. Such funds are usually able to achieve low correlations to the broader financial markets. The approach generally involves a medium- to long-term holding period.

Drawdown

The percentage loss that a fund incurs from its peak net asset value to its lowest value. The maximum drawdown over a significant period is sometimes employed as a means of measuring the risk of a vehicle. Usually expressed as a percentage decline in net asset value.

Emerging-markets investment strategy

Investing in stocks or bonds issued by companies and government entities in developing countries, usually in Latin America, Eastern Europe, Africa and Asia. Such funds typically employ a short- to medium-term holding period and experience high volatility.

Equity Discretionary

Investing long/short the equity markets based on qualitative and fundamental analysis and taking into consideration market and company specific conditions.

Equity Long / Short

(Large & Mid Cap, Small & Micro Cap, US, Europe, Japan & Asia, Technology & Biotech, Utility, Financial)

Investing in a core long equities portfolio and hedging by selling short equity or using options and futures. Managers adapt their net long and net short exposure according to expected market conditions. They may focus on equities according to market cap, geographic location and market sector.

Equity Systematic

Investing long/short the equity markets based on trend-following or other quantitative analysis. Computer programs also known as "black boxes" give buy and sell signals.

Equity Market Neutral

Having equally long and short positions in related equity securities and being dollar, beta and sector neutral to reduce market risk exposure.

Event-driven investment strategy

An approach that seeks to anticipate certain events, such as mergers or corporate restructurings. Such funds, which include risk-arbitrage vehicles and entities that buy distressed securities, typically employ medium-term holding periods and experience moderate volatility.

Fixed income investment strategy

An approach in which the manager invests primarily in bonds, annuities or preferred stock. The investments can be long positions, short sales or both. Such funds are often highly leveraged.

Fixed-income arbitrage investment strategy

An approach that aims to profit from pricing differentials or inefficiencies by purchasing a bond, annuity or preferred stock and simultaneously selling short a related security. Such funds are often highly leveraged.

Fixed Income Arbitrage (2)

Seeking profit by exploiting pricing inefficiencies in the global fixed income markets by taking long / short positions in related fixed income securities. For example taking a long position in a government bond and selling futures of the same bond.

Fund of funds (multi-manager vehicle)

An investment vehicle whose holdings consist of shares in hedge funds and private-equity funds. Some of these multi-manager vehicles limit their holdings to specific managers or investment strategies, while others are more diversified. Investors in funds of funds are willing to pay two sets of fees, one to the fund-of-funds manager and another set of (usually higher) fees to the managers of the underlying funds

Fundamental analysis investment strategy

An approach that relies on valuing stocks by examining companies' financials and operations, including sales, earnings, growth potential, asset size and quality, indebtedness, management, products and competition.

General partner

The individual or firm that organizes and manages a limited partnership, such as a hedge fund. The general partner assumes unlimited legal responsibility for the liabilities of a partnership.

Global-macro investment strategy

An approach in which a fund manager seeks to anticipate broad trends in the worldwide economy. Based on those forecasts, the manager chooses investments from a wide variety of markets -- i.e. stocks, bonds, currencies & commodities. The approach typically involves a medium-term holding period and produces high volatility. Many of the largest hedge funds follow global-macro strategies. They are sometimes called "macro" or "global directional-investment" funds.

Hedge fund

A private investment vehicle whose manager receives a significant portion of its compensation from incentive fees tied to the fund's performance -- typically 20% of annual gains over a certain hurdle rate, along with a management fee equal to 1% of assets. The funds, often organized as limited partnerships, typically invest on behalf of high-net-worth individuals and institutions. Their primary objective is often to preserve investors' capital by taking positions whose returns are not closely correlated to those of the broader financial markets. Such vehicles may employ leverage, short sales, a variety of derivatives and other hedging techniques to reduce risk and increase returns. The classic hedge-fund concept, a long/short investment strategy sometimes referred to as the Jones Model, was developed by Alfred Winslow Jones in 1949.

High-water mark

A provision serving to ensure that a fund manager only collects incentive fees on the highest net asset value previously attained at the end of any prior fiscal year -- or gains representing actual profits for each investor. For example, if the value of an investor's contribution falls to, say, $750,000 from $1 million during the first year, and then rises to $1.25 million during the second year, the manager would only collect incentive fees from that investor on the $250,000 that represented actual profits in year-two.

Hurdle rate

The minimum return necessary for a fund manager to start collecting incentive fees. The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread. If, for example, the manager sets a hurdle rate equal to 5%, and the fund returns 15%, incentive fees would only apply to the 10% above the hurdle rate.

Incentive fee (performance fee)

The charge -- typically 20% -- that a fund manager assesses on gains earned during a given 12-month period. For example, if a fund posts a return that is 40% above its hurdle rate, the incentive fee would be 8% (20% of 40%) -- provided that the high-water mark does not come into play.

Inception date

The day on which a fund starts trading.

Lamp letter

A May 6, 1997, "no-action letter" from the SEC to Lamp Technologies of Dallas indicating that an online hedge-fund database would not violate restrictions against marketing hedge funds. The landmark letter cleared the way for others to launch hedge-fund performance databases on the Internet, and expressed the SEC's opinion that such databases did not represent the type of general hedge-fund advertising that was prohibited under rule 502(c) of Regulation D under the Securities Act of 1933

Leverage

The borrowed money that an investor employs to increase buying power and increase its exposure to an investment. Users of leverage seek to increase their overall invested amounts in hopes that the returns on their positions will exceed their borrowing costs. The extent of a fund's leverage is stated either as a debt-to-equity ratio or as a percentage of the fund's total assets that are funded by debt. Example: If a fund has $1 million of equity capital and it borrows another $2 million to bring its total assets to $3 million, its leverage can be stated as "two times equity" or as 67% ($2 million divided by $3 million). Ratios of between two and five to one are common. Leverage can also come in the form of short sales, which involve borrowed securities

Limited partnership

Many hedge funds are structured as limited partnerships, which are business organizations managed by one or more general partners who are liable for the fund's debts and obligations. The investors in such a structure are limited partners who do not participate in day-to-day operations and are liable only to the extent of their investments.

Lock-up

The period of time -- often one year -- during which hedge-fund investors are initially prohibited from redeeming their shares.

Long-biased investment strategy

An approach taken by fund managers who tend to hold considerably more long positions than short positions.

Long/short investment strategy

An approach in which fund managers buy stocks whose prices they expect will increase and takes short positions in securities (usually in the same sector) whose prices they believes will decline. The strategy, also known as the Jones Model, is designed to generate profits during bullish periods in the overall stock market, while serving as a source of capital protection in a falling stock market.

Managed futures

A vehicle in which an investor gives a commodity trading advisor -- usually a manager or broker -- discretion or authority to buy and sell futures contracts, either unconditionally or with restrictions.

Managed Account

A type of discretionary account, where the owner remains liable of the obligations of the derivative.  Funds within a managed do not represent part of a managers AUM, as the funds remain the ownership of the account holder. Managed futures use this type of an account. The owner often has total transparency of the underlying positions and rapid access to funds. 

Management fee

The charge that a fund manager assesses to cover operating expenses. Investors are typically charged separately for costs incurred for outsourced services. The fee generally ranges from an annual 0.5% to 2% of an investor's entire holdings in the fund, and it is usually collected on a quarterly basis.

Market-neutral investment strategy

An approach that aims to preserve capital through any of several methods and under any market conditions. The most common followers of the market-neutral strategy are funds pursuing a long/short investment strategy. These seek to exploit market discrepancies by purchasing undervalued securities and taking an equal, short position in a different and overvalued security. Market-neutral funds typically employ long-term holding periods and experience moderate volatility.

Macro Global

Seeking to profit from changes in global economies. Managers forecast shifts in world economies influenced by major economic trends and events. Managers employ a "top-down" global approach, and may trade equities, debt, currencies, futures, options and commodities.

Market Timing

Allocating assets among investments, attempting to time the market by switching between different asset classes such as mutual funds and money markets.

Master-feeder fund

A common hedge-fund structure through which a manager sets up two separate vehicles -- one based in the U.S. and an offshore fund that is domiciled outside the U.S. -- which serve as the only investors for a third non-U.S. fund. The two smaller entities are known as feeder funds, while the large offshore vehicle acts as the master fund. The purpose of such an arrangement is to create a single investment vehicle for both U.S. and non-U.S. investors.

Merger arbitrage investment strategy

Trading the stocks of companies that have announced acquisitions or are the targets of acquisitions. Seeks to exploit deviations of market prices from proposed exchange formulas.

Mortgage-backed securities arbitrage investment strategy

An approach that seeks to exploit pricing differentials between various issues of mortgage-related bonds.

Multi-Strategy / Multi-Advisor

Allocating investment capital to more than one strategy or advisor to combine different trading techniques and manager skills. This allows more investment opportunities and greater risk control.

Offshore fund

An investment vehicle that is domiciled outside the U.S. and has no limit on the number of non-U.S. investors it can take on. Although the fund's securities transactions occur on U.S. exchanges and are executed by a U.S. manager, or general partner, its administration and audits are conducted offshore -- usually in a tax haven like the Cayman Islands. Because it is administered outside the U.S., non-U.S. investors and such U.S. investors as pension funds and other tax-exempt entities aren't subject to U.S. taxes.

Option

Managers focus on options such as selling call options or buying put options to hedge a portfolio of long positions. Option arbitrage captures the spread between similar options through inefficiencies in the market.

Opportunistic investment strategy

An approach that seeks to produce the greatest possible returns by making aggressive investments in the most-efficient products at a given time. Such funds typically hold their investments for five to 30 days, based on the momentum of the investments' values. They usually experience low volatility.

PIPEs

Acronym for private investments in public entities. Investments typically made by funds following Regulation D investment strategy.

Prime broker

A large bank or securities firm that provides various administrative, back-office and financing services to hedge funds and other professional investors. Prime brokers can provide a wide variety of services, including trade reconciliation (clearing and settlement), custody services, risk management, margin financing, securities lending for the purpose of carrying out short sales, record keeping, and investor reporting. A prime brokerage relationship doesn't preclude hedge funds from carrying out trades with other brokers, or even employing others as prime brokers. To compete for business, some prime brokers act as incubators for funds, providing office space and services to help new fund managers get off the ground.

Private-equity fund

Entities that buy illiquid stakes in privately held companies, sometimes by participating in leveraged buyouts. Like hedge funds, the vehicles are structured as private investment partnerships in which only qualified investors may participate. Such funds typically charge a management fee of 1.5% to 2.5%, as well as an incentive fee of 25% to 30%. Most private-equity funds employ lock-up periods of five to ten years, longer than those of hedge funds

Private placement

Issues those are exempt from public-registration provisions in section 4-2 of the Securities Act of 1933. Hedge fund shares are generally offered as private placements, which are typically offered to only a few investors, rather than the general public. They must meet the following criteria:

• The issuer must believe that the buyer is capable of evaluating the risks of the transaction.
• Buyers have access to the same information that would appear in the prospectus of a publicly offered issue.
• The issuer does not sell the securities to more than 35 parties in any 12-month period.
• The buyer does not intend to sell the securities immediately for a trading profit.

R-squared

A measure of the degree to which a hedge fund's returns are correlated to the broader financial market. A figure of 1 would be a perfect correlation, while 0 would be no correlation and minus-1 would be a perfect inverse correlation. Any figure below 0.3 is considered non-correlated. The result is used to determine whether a hedge fund follows a market-neutral investment strategy. Sometimes referred to as "R."

Rate of return

The annual appreciation in the value of a fund or any other type of investment, stated as a percentage of the total amount invested. Sometimes referred to a simply the "return."

Redemption fee

A charge, intended to discourage withdrawals that a hedge-fund manager levies against investors when they cash in their shares in the fund before a specified date

Regulation D

A provision in the Securities Act of 1933 that allows privately placed transactions to take place without SEC registration and prohibits hedge funds from advertising themselves to the general public. It also outlines which parties qualify as company insiders.

Regulation D investment strategy

An approach in which the fund manager provides financing to publicly traded companies, usually in exchange for a privately placed convertible note issued at a discount. Also known as PIPES (private investments in public entities).

Relative-value investment strategy

A market-neutral investment strategy that seeks to identify investments whose values are attractive, compared to similar securities, when risk, liquidity and return are taken into account.

Risk arbitrage investment strategy

Purchasing stocks of companies that are likely takeover targets, while assuming short positions in the would-be acquiring companies. Risk arb players can employ an event-driven investment strategy or merger arbitrage investment strategy, seeking situations such as hostile takeovers, mergers and leveraged buyouts. Such funds typically experience moderate amounts of volatility.

Risk-free rate

The theoretical return on a risk-free investment, usually a U.S. security.

Sharpe ratio

A measure of how well a fund is rewarded for the risk it incurs. The higher the ratio, the better the return per unit of risk taken. It is calculated by subtracting the risk-free rate from the fund's annualized average return, and dividing the result by the fund's annualized standard deviation. A Sharpe ratio of 1:1 indicates that the rate of return is proportional to the risk assumed in seeking that reward. Developed by Prof. William R. Sharpe of Stanford University.

Short-biased investment strategy

An approach that relies on short sales. Such funds tend to hold larger short positions than long positions.

Short Term

Trading long/short equity by holding positions for a short duration. This includes day-trading where managers try to profit from intra-day volatility of the equity.

Short Selling

Selling securities short in expectation to buy them back at a future date at a lower price. Managers short the securities and markets as they believe they are overvalued.

Soft dollars

Credits that can be used to pay for research and other services that brokerage firms provide to hedge funds and other investor clients in return for their business. Those credits are accumulated through soft-dollar brokers, which channel trades to multiple securities brokers.

Sortino ratio

Also called the "upside potential ratio." Similar to the Sharpe ratio, it was developed by the Pension Research Institute to determine the amount of "good" volatility that a fund's investment portfolio possesses -- that is, it seeks to define the amount by which the investment pool's value may increase, based on expected pricing fluctuations.

Special situations investment strategy

An event-driven investment strategy in which the manager seeks to take advantage of unique corporate situations that provides the potential for investment gains.

Standard deviation

For an investment portfolio, it measures the variation of returns around the portfolios mean-average return. In other words, it expresses an investment's historical volatility. The further the variation from the average return, the higher the standard deviation.

Statistical arbitrage investment strategy

A market-neutral investment strategy that seeks to simultaneously profit and limit risk by exploiting pricing inefficiencies identified by mathematical models. The strategy often involves short-term bets that prices will trend toward their historical norms.

Strategy

The investment disciplines and strategies used by hedge fund managers are diverse and distinct. Each offers different degrees of risk, return, volatility and correlation.

Top-down investment strategy

An approach that seeks to assess the influence of various macro-and micro-economic factors before identifying individual investments.

Value investment strategy

An approach that involves purchases of stocks that the manager deems to be priced below their intrinsic values, or are out of favor with the market but are still fundamentally solid. Such funds typically employ long-term holding periods and experience low volatility.

Venture capital

Money given to corporate start-ups and other new high-risk enterprises by investors who seek above-average returns and are willing to take illiquid positions.

Volatility

The likelihood that an instrument's value will change over a given period of time, usually measured as beta.

Worst Consecutive Monthly Period

The worst return period consisting of only consecutive losing months.