Absolute Returns
The pursuit of positive returns rather than attempting to outperform a benchmark
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 that was one percentage point higher than the benchmark Treasury, during that month. Alpha can also be used as a measure of residual risk, relative to the market in which a fund participates.
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.
Correlation
A measurement of relationship between two variables. The correlation coefficient (r) shows if there is any correlation between an asset and the market. 1.0 is perfect correlation, 0.0 is absolutely no correlation, and –1.0 is a perfect negative correlation. Studies indicate that a correlation coefficient below 0.3 has no correlation to the market.
Derivatives
A financial instrument whose performance is linked to another 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.
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.
Fund of funds
A fund which invests into a portfolio of underlying funds and strategies.
Hedging
A strategy designed to reduce investment risk using call options, put options,short selling, or futures contracts. A hedge can help lock in existing profits. Its purpose is to reduce the potential volatility of a portfolio, by reducing the risk of loss.
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 n 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.
Leverage
The leverage is the measure of assets being ‘borrowed’ against the investment dollar. Leveraging, or the borrowing of additional funds, is used when the cost of the borrowed funds will be comparatively minimal to that of the returns gained by a particular position.
Lock-up
The period of time -- often one year -- during which hedge-fund investors are initially prohibited from redeeming their shares.
Long Position
Owning a particular security.
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.
Multi-strategy
Allocation of capital to a variety of different investment strategies.
NAV
Net asset value of a fund's shares or units.
Performance Fee
To reward manager for good performance.
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.
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.
Risk
Exposure to uncertain change, upside (positive change) or downside (negative change). There are many types of risk associated with investments (e.g., market risk, political risk). There are also many statistical measures, such as standard deviation, used to understand and estimate risk associated with investments.
Risk-Adjusted Return
Investment performance adjusted for the level of risk that the strategy is exposed to. Usually risk is measured by standard deviation or the volatility that is demonstrated by the strategy. Typically, investments showing high return will have an increased level of volatility or a higher standard deviation.
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 selling (going short)
The selling of a security that the seller does not own, in anticipation that the stock price will fall and that they will consequently be able earn a profit by repurchase the stock at the lower price and selling in the future for a higher price.
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.
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.
Volatility
The likelihood that an instrument's value will change over a given period of time, usually measured as beta.
