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. 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 factor 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.
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 bankrupts 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.
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.
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.
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. A type of discretionary account
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.
Market timer
A hedge-fund manager that selects asset allocations in anticipation of movements in the broad market.
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
An investment style that combines several different approaches. The term often applies to funds of funds
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.
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.