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Hedge Funds

Industry Definitions

In this article


Discover the many definitions associated with hedge funds, from performance and strategies to investment methodology.

Structures

Alternative Mutual FundA ’40 Act mutual fund that uses an alternative strategy similar to a hedge fund. Retains the typical characteristics of a traditional mutual fund such as a US domicile, daily liquidity, and no performance/incentive fee.
Commingled FundAn investment structure that pools investments from multiple external investors into one account managed or advised by the fund manager. Investors share in the assets of the fund.
Domestic FeederAn onshore-domiciled feeder fund designed for US taxable investors. These investors take advantage of investing in a US limited partnership feeder fund which is tax effective for such US taxable investors.
Fonds Commun de Placement (FCP)A contractual undertaking for collective investment, based on the legal investment structures in Luxembourg.
Listed FundA fund that is listed on a smaller market exchange – such as the Irish Stock Exchange – usually in order to provide a degree of regulatory oversight demanded by investors. This type of fund is identified with an ISIN number.
Managed AccountA vehicle sub-advised by a hedge fund manager whose role is limited to the right to make investment decisions on behalf of an investor. Investors own actual assets as opposed to limited partnership interests in a pool of assets. They also have full transparency of the assets being managed and may tailor the portfolio according to their specific needs. They may also nominate their own service providers as a way of lowering counter-party risk. Due to the operational and logistical difficulties of this arrangement for the manager, a sizeable capital commitment is required from investors in order to open a managed account.
Master FeederStructure that is commonly used to accumulate funds raised from each of US taxable, US tax-exempt and non-US investors into one central master fund. This is in order to enhance the critical mass of tradable assets, improve the economies of scale under which the fund operates and enhance operational efficiencies, thereby reducing costs such as tax. The structure generally involves the use of a master fund company (incorporated in a tax-neutral offshore jurisdiction e.g. Cayman Islands or Bermuda) into which separate distinct feeder funds invest.
Open-Ended Investment Company (OEIC)A fund structured to invest in other companies with the ability to constantly adjust its investment criteria and fund size.
Offshore FeederAn offshore-domiciled feeder fund designed for non-US and US tax-exempt investors that wish to subscribe via a separate offshore feeder company to avoid coming directly within the US tax regulatory net applicable to US taxable investors.
Qualifying Investor Fund (QIF)A regulated vehicle aimed at Irish investors which allows the use of leverage and the holding of derivative products. This is a flexible vehicle which can quickly be brought to market.
Société d’Investissement à Capital Variable (SICAV)

A SICAV is a fund structure that is common throughout Western Europe, especially in Luxembourg, Switzerland, Italy, Spain, Belgium, and France. SICAVs are typically open-ended, but may also be closed-end.
Side by Side – DomesticIn a side-by-side – domestic structure, US investors typically invest in a limited partnership organized in the US. This fund runs parallel to an offshore structure which follows the same strategy as the domestic fund. However, there are certain inherent inefficiencies in management; for example, the manager must allocate trades among its domestic fund and offshore fund while trying to achieve equivalent returns between the two.
Side by Side – OffshoreIn a side-by-side – offshore structure, both US tax-exempt and non-US investors typically invest in an offshore corporation. This fund runs parallel to an onshore structure which follows the same strategy as the offshore fund. The same inefficiencies apply to side-by-side offshore as to their domestic counterparts.
Standalone – DomesticA domestic partnership that invests without ‘feeding’ into or investing alongside another vehicle.
Standalone – OffshoreThe most common structure for offshore managers with no US presence and that therefore expect to gear the fund predominately to non-US investors (and possibly US tax-exempt investors).
Undertakings for Collective
Investment in Transferable
Securities (UCITS)
The European regulatory framework for an investment vehicle which allows it to be marketed to investors across the EU. It aims to promote high levels of investor protection through greater transparency of investment activity. UCITS funds have to offer their investors at least fortnightly liquidity and monthly transparency documentation outlining the strategy and investments of the fund. UCITS funds have restrictions on the underlying investments that they are allowed to make as well as a cap on the level of leverage they are allowed to employ.


Performance

Annualized PerformanceAnnualized returns express a fund’s rate of return on an annual basis, or a return per year, over a given time period. This is calculated as a geometric mean of the reported monthly returns (M) for the given time period in the following manner: ((1 + M1) x (1 + M2) x ... (1 + Mn) ^ 12/n) - 1. The annualized performance represents the rate of return that, if compounded each year, would produce the cumulative return for the same period. It is a measure that describes the change in a fund’s net asset value as if it grew or declined at the same rate each year during the period. The annualized performance is typically measured over trailing periods greater than 12 months, such as three years, five years or 10 years. It is also commonly measured for the entire period since a fund’s inception.
Asset FlowsThe net of all cash inflows and outflows at either industry, strategy, region, or fund level.
Average MonthThe average (mean) of a fund’s individual monthly returns. The average positive month provides an average of all months in which a return of zero or greater has been recorded. The average negative month is an average of all months in which a loss has been recorded.
Best Month/Worst MonthThe best month represents the highest net return achieved by the fund in a single month. The worst month represents the lowest net return achieved by the fund in a single month.
Constituent FundsA list of all the funds that contribute to the benchmark return. To avoid benchmarks being weighted by a single fund, only one share class per fund appears in any one benchmark, and only one fund or share class per master-feeder structure can appear in any one benchmark. Consequently, constituent fund lists are smaller than the number of funds for which returns are available for a particular period. Contributing funds and share classes are chosen based on set criteria, with those with the longest track record prioritized.
Cumulative PerformanceThe aggregate percentage increase or decrease in a fund’s net asset value over a given period of time. This is calculated by geometrically linking the reported monthly returns (M) for the given time period in the following

manner: (1 + M1) x (1 + M2) x ... (1 + Mn) - 1
The cumulative performance is typically measured over trailing periods such as the past three months, one year, three years or five years. It is also commonly measured for individual years, the current calendar year (year to date), and the entire period since a fund’s inception.

Distribution of Monthly Returns

An overview of the frequency of distribution of a fund’s monthly returns. This provides an insight into the number of a fund’s monthly returns that are close to the average return and the number that are extreme values (outliers).
Downside DeviationUnlike standard deviation, this risk measure only takes account of returns that fall below a defined minimum acceptable return (MAR). The excess returns for each month (or other period) are calculated and those that are positive are taken as zero values. The sum of the squares of the negative excess returns is taken. The downside deviation is then the square root of the mean (sum of squares divided by number of returns).
Drawdown LengthThe number of months between a fund’s highest net asset value and its lowest net asset value (before recovering to its previous peak level).
Drawdown PeriodA drawdown period represents the period of time when the fund net asset value has declined from a previous peak. The period ends when the fund’s net asset value reaches its lowest point (before recovering to its previous peak). The lowest net asset value, and therefore the drawdown period, can only be determined once the fund has fully recovered to its previous peak net asset value.
Drawdown SizeThe percentage loss that a fund incurs from its peak net asset value to its lowest net asset value (before recovering to its previous peak level).
Emerging ManagerA fund manager with a track record of less than two years.
Excess Return Provides an indication of the degree to which the fund has been successful at adding value or meeting a hurdle rate. Calculated by subtracting a predetermined rate of return (such as a risk-free rate, minimum acceptable return, or benchmark return) from the net return of a fund over a specified period. It is used in the calculation of statistics such as the Sharpe and Sortino ratios.
Investment Growth/Value Added Monthly Index (VAMI)The growth of a hypothetical $1,000 investment in a fund. VAMI is calculated as follows:
Previous VAMI x (1 + current return). It can be taken as a proxy for a fund’s net asset value to calculate other statistics, such as a fund’s drawdowns.
KurtosisA measure of how peaked or flat a fund’s return distribution is, relative to a normal distribution. Positive kurtosis indicates a peaked distribution, with returns close to the mean and a higher frequency of outliers (in the shape of very high returns or significant losses). Negative kurtosis indicates a flatter distribution, with frequent and moderate deviations from the mean. The kurtosis measure used is adjusted to give excess kurtosis, which represents the level of kurtosis in relation to a normal distribution. A normal distribution is an important assumption of statistics such as the Sharpe ratio.
Market BenchmarksBenchmark returns comprise unweighted averages of constituent fund returns and provide an indication of industry and sub-sector performance in individual months and over longer periods. Funds are grouped based on their type, key strategy, sub-strategies, geographic scope, and currency denomination.
Minimum Acceptable Return (MAR)Used in the calculation of the excess return in the Sortino ratio, and in the calculation of downside and upside deviation. It is typically set according to the individual investor’s goals and can reflect the risk-free rate, the return of another benchmark, zero, or some other target.
Monthly Returns (Net, %)The percentage change in the fund’s month-end net asset value from the previous month-end net asset value, after fees have been deducted. Net-of-fees returns are used to provide an indication of fund performance from the perspective of investors.
NAV per UnitThe net asset value per share of a fund. Represents the market value of a fund’s total net assets (total assets minus liabilities) divided by the number of shares outstanding. In many, but not all, cases this is the unit price or share price for new and existing investors in a fund.
Performance Date/As At DateThe date to which the performance statistic is measured. This reflects the last, or most recent, monthly return used in the calculation.
Recovery LengthThe number of months between a fund’s lowest net asset value and its new peak (or recovery of its previous peak) net asset value.
Risk-Free Rate (RFR)The theoretical return of an investment with no risk. This is subtracted from a fund’s actual returns to generate the excess return. It is factored into statistics such as the Sharpe ratio to account for the assumption that any investment with a degree of risk attached should deliver greater returns than the risk-free rate.
Sharpe RatioProvides an indication of a fund’s returns relative to its level of risk. Calculated by subtracting a predetermined risk-free rate from the annualized period return to generate the fund’s excess return, then divided by the fund’s volatility over the same period. In general, the higher the Sharpe ratio, the better the risk/reward characteristics of a fund and volatile returns are not necessarily bad, provided they are accompanied by a proportionally higher return. The exception to this is a negative Sharpe ratio as a negative excess return will mean higher amount of risk will have a positive influence on the ratio. It should be enough to know that a Sharpe ratio is negative, without knowing its magnitude, as this indicates the fund has not generated additional returns by taking on extra risk.
SkewA measure of the asymmetry of a distribution about the mean return. A positively skewed distribution is characterized by many low returns or losses and a few large returns. It is said to have a long right tail. A negatively skewed distribution is characterized by many high returns and a few low returns or losses. It is said to have a long left tail. A normal distribution is an important assumption of statistics such as the Sharpe ratio.
Sortino RatioProvides an indication of a fund’s returns relative to its level of downside risk. It is similar to the Sharpe ratio but the Sharpe ratio can be negatively affected by volatility on the upside, as well as on the downside. In contrast, the Sortino ratio assumes that investors are tolerant of volatile returns if gains are being made. A fund’s excess return (annualized return minus a pre-determined minimum acceptable return) is divided by its downside deviation below the minimum acceptable return.
VolatilityMeasured by the annualized standard deviation of monthly returns during the specified period. An annualized figure is approximated by multiplying the standard deviation of monthly returns by the square root of 12 (for the number of periods in a year).
Year to DateThe cumulative return of a fund during the calendar year.


Strategies

130/30A 130/30 ratio implies shorting stocks up to 30% of the portfolio value and then using the funds to take a long position in the stocks the investor feels will outperform the market.
Alternative Long Only A strategy that takes exclusively long positions in equities but also utilizes more alternative characteristics such as the prudent use of leverage or the use of derivatives for hedging purposes only. The fund will typically target absolute returns as opposed to returns relative to a benchmark, charge a performance fee and be aimed at more sophisticated investors.
Alternative Risk PremiaAims to generate returns above the risk-free rate by systematically investing in alternative sources of return or factors. The strategy is actively managed and can invest long and short across multiple asset classes. This strategy tends to offer high liquidity to investors due to the frequent trading and rebalancing.
Asset-Backed Lending StrategiesA type of financing in which the asset bought is used as collateral. In asset-backed lending, the quality of the collateral and not the financial strength of the borrower is of prime importance.
Capital Structure ArbitrageFunds that attempt to exploit the pricing inefficiency that exists in the capital structure of the same firm.
CommoditiesFocused on investments in raw materials and/or primary agricultural products such as grains, meats and orange juice that can be bought and sold on a Commodities Exchange.
Convertible ArbitrageFunds that attempt to exploit profits when there is a pricing error made in the conversion factor of the convertible security.
CryptocurrencyInvests in cryptocurrencies directly or crypto-related securities. Can deploy strategies like long-only buy and hold, ICO investment or active trading through shorting, futures and relative value trading.
DirectionalA strategy used by investors that open positions, either long or short, in the belief that they are able to correctly predict the movement of price in a security.
DistressedA strategy that buys deeply discounted equity, debt or trade claims of companies in or facing bankruptcy or reorganization.
DiversifiedFor a fund of hedge funds, diversified implies its underlying funds invest across multiple hedge fund strategies. This is as opposed to a fund of hedge funds investing in multi-strategy-specific funds, i.e. funds that focus on managing a multi-strategy-themed vehicle.
Equity Market NeutralStrategy that seeks to exploit differences in stock prices by being long and short in stocks within the same sector, industry, market capitalization, country, etc. This strategy creates a hedge against market factors.
Event DrivenStrategy that seeks to exploit pricing inefficiencies preceding or following corporate events such as bad news, distressed situations, mergers & acquisitions, recapitulations, or spin-offs.
Fixed IncomeApproach where a manager invests primarily in bonds (also annuities or preferred stock) which come with a fixed rate of interest (coupon) payable to the bondholder at maturity. Such funds are often highly leveraged.
Fixed Income ArbitrageStrategy that consists of the discovery and exploitation of inefficiencies in the pricing of bonds.
Foreign ExchangeFunds that trade currencies on the foreign exchange market.
Insurance-Linked StrategiesStrategy linked to different forms of underlying insurance-related risk such as life/longevity products, natural catastrophes, and industry loss etc. This strategy offers little to no correlation with the capital markets.
Long BiasFund biased towards buying and holding securities such as a stock, commodity, or currency, with the expectation that the assets will rise in value.
Long/Short CreditTakes long and short positions in credit instruments such as investment grade, high yield, convertible, or distressed debt in order to take advantage of opportunities in these asset classes. Views based on credit analysis of issuers and securities.
Long/Short EquityBuying undervalued stocks and selling short overvalued stocks (usually in the same sector). Long/short funds typically benefit from variable exposure (they can be net long, market neutral, or even net short) and the use of leverage.
MacroAims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Participates in all major markets – equities, bonds, currencies and commodities – though not always at the same time.
Managed Futures/Commodity Trading Advisors (CTA)CTAs look after managed futures accounts, deciding on their positions based on expected profit potential. This will incorporate buying and selling commodity futures or futures options. Managed futures offer the potential for reduced portfolio volatility and the ability to earn profit in any economic environment.
Real EstateA fund investing in the real estate market – can include investment in various property types.
Relative Value ArbitrageRelative value strategies generate profits by capturing the spread between two closely related securities. For example, an investor can buy relatively undervalued off-the-run US Treasury Bills and simultaneously short relatively overvalued on-the-run US Treasury Bills with the same duration.
Risk/Merger ArbitrageForm of arbitrage that typically involves the simultaneous purchase of shares in one company (the takeover target) and the short sale of shares in another (the acquirer). This strategy is typically used once a merger or acquisition has been announced and aims to capture the spread between the current price of the target’s equity and the price offered by the acquirer.
Sector-FocusedA fund that invests solely in businesses that operate in a particular industry or sector of the economy.
Short BiasFund is biased towards the act of borrowing stock to sell high today with the expectation of buying it back at a lower price in the future and then returning the stock to the lender.
Specialist CreditInvests purely on credit investment and employs a number of credit strategies.
Special SituationsTargets investment in event-driven situations such as mergers & acquisitions, hostile takeovers, reorganizations, or leverage buyouts.
Statistical ArbitrageMathematical modelling techniques are used to identify pricing inefficiencies between securities in order to make a profit.
Value-Oriented Invests in securities perceived to be selling at deep discounts to their intrinsic or potential worth. Such securities may be out of favour or underfollowed by analysts. Long-term holding, patience, and strong discipline are often required until the ultimate value is recognized by the market.
Variable BiasFund that is able to take on elements of long and short bias.


Alternative risk premia

CarryTrading strategy that involves borrowing at a low interest rate and investing in an asset that provides a higher rate of return. The tendency being that higher-yielding assets provide higher returns than lower-yielding assets.
DefensiveSeeks returns from low-risk strategies, generating incremental gains without taking on large amounts of risk.
Liquidity/SizeInvesting on the assumption that smaller stocks will outperform their larger peers.
Mean ReversionInvesting on the assumption that all assets will revert to their long-term means over time.
MomentumInvestors buy recently outperforming assets and sell short recently underperforming assets. The typical approach is to look at the past 12 months of returns for a universe of assets, going long on the ones that have outperformed their peers, and shorting the underperformers. Inherent part of the majority of trend-following CTAs.
ValueSeeks value in underlying positions.
VolatilityChoosing an acceptable volatility target level and rebalancing a traditional 40/60 portfolio to ensure it hits that level of risk. The strategy can also be referred to as ‘risk parity investing’.


CTAs

ArbitrageObjective to capitalize on the price difference between similar stocks trading on different markets. The price discrepancies are spotted by the manager which is exposed to some risk in the form of price fluctuations and the
devaluation of a currency or derivative.
Counter TrendTrading strategy in which investors buy or sell counter to the direction of the market. It looks to pick the top or bottom of the market using technical analysis and quick decision-making.
MacroAims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, which in turn affects currency, equity, and bond markets. Participates in all major markets, though not always at the same time.
Multiple StrategyCTA that opts for at least two of arbitrage, counter-trend, macro, option-writing, pattern-recognition, or trendfollowing strategies.
Option WritingStrategy that involves the collection of premiums in return for offering risk insurance to other market participants.
Pattern RecognitionTechnique used to forecast price moves based on the identification of trading patterns or technical indicators such as flags and channels.
Single StrategyCTA focused on one strategy, usually one of arbitrage, counter trend, macro, option writing, pattern recognition, or trend following.
Trend FollowingTraders aim to profit by following short, medium- or long-term price trends in various markets. These trends arise from directional moves that reflect informational gaps, changes in sentiment, and supply/demand imbalances in markets.

 

Benchmark indices

London Interbank Offered Rate (LIBOR)The most commonly used benchmark for short-term interest rates. The LIBOR is fixed on a daily basis by the British Bankers’ Association.
MSCIAn index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performances.
Russell 3000Market capitalization-weighted equity index maintained by the Russell Investment Group that seeks to be a benchmark of the entire US market. This index encompasses the 3,000 largest US-traded stocks.
S&P 500An index from Standard & Poor, is a market-capitalization-weighted index of the 500 largest US publicly traded companies by market value.
Treasury Bill (T-Bill)A short-term debt obligation backed by the US Government with a maturity of less than one year.
Wilshire 5000A market capitalization-weighted index composed of over 5,000 publicly traded companies that meet the following criteria: the companies are headquartered in the US; the stocks are actively traded on an American stock exchange; the stocks have pricing information that is widely available to the public.


Investment methodology

ActivistFunds that generally buy a large enough part of a company to be able to actively participate in the management and decision-making, sometimes to catalyze change.
Artificial Intelligence/Machine LearningFund uses complex computer algorithms to replicate a human’s ability to learn and make predictions before executing trades autonomously. Funds can identify new investment opportunities across financial markets using a multitude of sources and can consider human insights to a greater degree than traditional systematic funds that rely on chart movement.
Bottom-upThe emphasis is firmly on the individual company in the belief that individual companies can thrive in spite of the non-performing industry in which it is based. This approach focuses on thorough due diligence and research of the target company. Polar opposite approach to ‘top-down’ investing.
CommoditiesRaw materials and/or primary agricultural products such as grains, meats, and orange juice that can be bought and sold on a Commodities Exchange.
CurrencyHedge funds that invest in currencies can implement a number of different strategies such as currency trading, currency options, and derivatives.
DebtThe amount of money borrowed by one party from another and on which a fixed rate of interest (coupon) is paid at a later date (maturity). Bonds, loans, and money-market instruments are examples of debt.
DerivativesA security whose price is dependent on, or derived from, one or more underlying assets. The derivative itself is merely a contract between two or more parties. Value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates, and market indices. Most derivatives are characterized by high leverage.
DiscretionaryA human system used to trade instruments that is characterized by proprietary approaches employing technical and/or fundamental analysis in a specific combination.
EquitiesStocks or other types of security that represent an ownership interest.
ETFsA basket of securities that trades an index but can also be traded like a stock on an exchange.
Forward ContractsContract stipulating an agreement between two parties for the agreed delivery and time for a security to be exchanged. The quantity and price of the asset to be delivered in the future is specified.
Futures ContractsContract between two parties used to take advantage of market price movements. The buyer of the futures contract agrees on a fixed purchase price to buy the underlying commodity from the seller at the expiration of the contract. The seller of the futures contract agrees to sell the underlying commodity to the buyer at expiration and at the fixed sales price. As time passes, the contract’s price changes relative to the fixed price at which the trade was initiated. This creates profits or losses for the trader.
OptionsGives an investor the right but not the obligation to buy an asset at a specific price and at a specific date or time.
SwapsThe exchange of one security for another between firms/traders for various reasons such as a change in investment objectives and the quality or maturity of the assets.
SwaptionsAn option entitling the owner to the right, but not the obligation, to enter into a swap agreement.
SystematicA computerized system using proprietary computer models to generate buy-and-sell decisions. The models utilize quantitative analysis of different technical factors.
Top-downApproach that focuses on the industry as a whole in which targeted stocks are based. This approach puts emphasis on the significance of economic and market cycles on the value of stocks, thereby assuming that the industry must be performing for an individual company or stock in that industry to do the same.
Trading Volatility Form of trading that seeks to take advantage of potential pricing movements in an asset, such as a stock. It is primarily traded through options as their value is directly affected by the volatility of its underlying asset.
Warrants A security that entitles the holder to purchase the stock of the issuing company at a fixed exercise price until the expiry date.


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