Absolute Return

The term indicates actual gain or loss without regard to market benchmarks or peer groups.

Alpha -α

A numerical value indicating a manager’s risk-adjusted excess rate of return relative to a benchmark. Measures a manager’s “value added” in selecting individual securities, independent of the effect of overall market movements.

ALSI (All Share Index)

The FTSE/JSE All Share Index, which is used as a proxy for the SA equity market. The index consists of the largest 160 stocks on the JSE, weighted according to their free float market caps.

Beta-β

Beta of a portfolio is the portfolio’s sensitivity to market movements. It represents the change in the portfolio’s return for every 1% change in the market return. The sign of the beta (+/-) indicates whether, on average, the portfolio’s returns move in line with the market (+) or in the opposite direction (-).

Beta - 1.0, returns tend to mirror the market.

Beta - 2.0, returns tend to be twice those of the market.

Beta - -0.5, returns tend to be half that of the market and moving in the opposite direction of the market.

Confidential Offering Memorandum

The confidential offering memorandum outlines the specific details of the hedge fund partnership, including the investment strategy, the background of the general partners, and contribution/withdrawal guidelines. An investor should read the confidential offering memorandum and the limited partnership agreement in its entirety before investing in a hedge fund partnership.

Correlation

A statistical measure of how two securities move in relation to each other. Correlation is computed into what is known as the correlation coefficient, which ranges between-1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move by an equal amount in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

Diversification

Generally refers to the variety of investments in a fund's portfolio.

Derivative

A financial instrument traded on or off an exchange, the price of which is directly dependent upon (i.e., "derived from") the value of one or more underlying securities.

Drawdown

The percentage loss that a fund incurs from its peak net asset value to its lowest value. The maximum drawdown represents the greatest peak to trough decline over the life of an investment.

Exposure

The extent to which a hedge fund is vulnerable to changes in a given financial market.

What is a general partner

A general partner oversees all aspects of the hedge fund partnership including the investment strategy, daily operations, and legal/accounting matters. The general partner invests its own capital along with the capital of the limited partners.

Hedge Fund

A hedge fund is a type of investment vehicle, typically structured as a private partnership, attempting to achieve superior risk-adjusted returns in all market environments. As a private partnership, hedge funds can use various techniques and strategies not commonly employed by public investment vehicles (i.e. hedge funds). Because of this, there can be an inherently higher level of risk associated with hedge funds.

High-Water Mark

The highest peak in value that an investment fund/account has reached. This term is often used in the context of fund manager compensation, which is performance based.

The high-water mark ensures that the manager does not get paid large sums for poor performance. So if the manager loses money over a period, he or she must get the fund above the high watermark before receiving a performance bonus.

Investment management fee

An investment management fee is the fee collected by the general partner to offset the day-to-day operations and administration of the hedge fund. Generally, it is 1% of the partnership’s assets on a per annum basis.

Leverage (Max)

Leverage is calculated as the sum of the absolute value of total long exposure and total short exposure of the fund divided by the fund size. Leverage is used as an indication of the fund’s exposure relative to its size. Leverage is sometimes also referred to as Total Gross Exposure or Gearing.

Limited partner

A limited partner is the technical term for an investor who invests capital in a hedge fund partnership. To become a limited partner, the investor has to read and sign the limited partnership agreement and subscribe to the general partner for partnership admission. Once accepted, the investor/limited partner shares in the profits and losses of the hedge fund. In most cases, a hedge fund will consist of 500 limited partners or less. Limited partners are only liable for the capital they commit to the partnership.

Lock-in period

A “lock-up” period is a contractually defined period of time in which the general partner may restrict a limited partner from redeeming his/her initial capital investment. This period of time can range from 6 months to over 2 years. Not all hedge funds have a “lock-up” period.

Long (or Long Position)

The buying of a security such as a stock, commodity or currency, with the expectation that the asset will rise in value.

Long / short strategy

In this strategy, hedge fund managers can either purchase stocks that they feel are undervalued or sell short stocks they deem to be overvalued. In most cases, the fund will have positive exposure to the equity markets – for example, having 70% of the funds invested long in stocks and 30% invested in the shorting of stocks. In this example, the net exposure to the equity markets is 40% (70%-30%) and the fund would not be using any leverage (Their gross exposure would be 100%). If the manager, however, increases the long positions in the fund to, say, 80% while still maintaining a 30% short position, the fund would have gross exposure of 110% (80%+30% = 110%), which indicates leverage of 10.

Market neutral strategy

In this strategy, a hedge fund manager applies the same basic concepts mentioned in the previous paragraph, but seeks to minimize the exposure to the broad market. This can be done in two ways. If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero. For example, if 50% of funds were invested long and 50% were invested short, the net exposure would be 0% and the gross exposure would be 100%. (Find out how this strategy works with mutual funds; read Getting Positive Results With Market-Neutral Funds.)

There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible. In either of the market-neutral strategies, the fund manager's intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks.

Either of these long short strategies can be used within a region, sector or industry, or can be applied to market-cap-specific stocks, etc. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles described here.

Net Asset Value (NAV)

The market value of a fund's total assets, minus its liabilities and intangible assets. The measure is used to determine prices available to investors for redemptions and subscriptions.

Calculating the NAV = “pricing the fund”.

Omega Ratio

The Omega ratio is a measure of risk of an investment asset, portfolio or strategy. Itinvolves partitioning returns into loss and gain above and below a given threshold (inthis case STeFI), the ratio is then the ratio of the probability of having a gain dividedby the probability of having a loss% Pos Months The percentage of months that the fund had positive returns.

Risk Free Return

The rate of return that can be earned with almost no risk. For this survey this rateis assumed to be the return that is earned on short dated fixed interest instruments as measured by the STeFI index.

Sharpe Ratio

The Sharpe ratio is calculated by subtracting the risk-free rate - such as the STeFI- from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed. The Sharpe ratio does however assume a normal distribution.

Short (or Short Position)

The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value %.

Standard Dviation

For an investment portfolio, it measures the variation of returns around the portfolio’s 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.

STeFI Index (Short Term Fixed Interest Index)

The STeFI index measures the performance of various short-term fixed interest instruments (max maturity of 1 year).

Sortino Ratio

The Sortino ratio measures the downside risk-adjusted return of the fund. It is calculated by deducting the risk free return from the fund return. The result is then divided by the fund’s downside deviation from the risk free rate.

Performance fee

A performance fee is the fee earned by the general partner after the hedge fund has achieved a pre-determined level performance. If the hedge fund does not achieve this level of performance, then the general partner does not earn the fee. Typically, an incentive can range from 10% - 30% of the partnership's profits.

Volatility

A statistical measurement of the rate of price change of a futures contract, security, or other instrument underlying an option.

Sources: Investopedia, AIMA HF Guide, Symmetry Multi-Managers

Understanding Hedge Funds

Who can invest in a hedge fund?

Hedge fund investments are not suitable for all investors. Hedge fund investing is typically limited to accredited investors, institutions, and a small number of “sophisticated” non-accredited investors. Investors should speak with their financial and tax advisors prior to making an investment in a hedge fund partnership.

How are hedge funds traded?

Since most hedge funds are private partnerships, they are not publicly traded like stocks or bonds. The general partner handles all contributions and redemptions of the partnership as a private transaction.

How do hedge funds fit in an asset allocation strategy?

Depending on an investor’s risk profile and return objectives, hedge funds can comprise a small or large portion of an asset allocation strategy. A 5% to 10% portfolio allocation to hedge funds is common, but every investor’s situation is different. A professional independent analysis should be conducted prior to deciding on a hedge fund allocation.