Hedge Fund Terminology: Part 1
New to the world of hedge fund investing? Not to fret. In this two-part series, we will walk through and outline the most relevant hedge fund terminology.
First and foremost, it's important to understand what a hedge fund is and who is permitted to invest in them.
A hedge fund is a type of investment fund that has reduced legal/regulatory oversight and fewer investing constraints than the more widely available mutual fund structure. A hedge fund has a larger investment universe to select from, whether that is private securities, distressed debt, or derivative contracts.
Hedge funds are actively managed and can utilize leverage. Unlike mutual funds, which are required to offer daily liquidity, hedge funds offer periodic liquidity, which can be on a monthly, quarterly, annual (or even longer) basis. While mutual funds only have a management fee, hedge funds are typically also compensated based on their performance.
Due to the various complexities and sophistication levels between mutual funds and hedge funds, only certain individuals (i.e., accredited investors, qualified purchasers) or entities are permitted to invest in the latter.
Because hedge funds have a larger investment universe to select from, there is a range of strategies that hedge fund managers employ, and as expected, there is not a single methodology to classify each of the categories. But it’s important to be familiar with a few of the main types of hedge fund strategies so that you are familiar with the various investment objectives and the risk and return expectations associated with them.
Hedge Fund Strategies
- Equity Long-Short – Focus on equity markets or equity-oriented risk. These Funds typically Buy as well as Short Sell (bet against) stocks of companies based on their views of the individual companies. Views are typically informed by company-specific or industry fundamentals but can also be based on technicals. Equity Long-Short Funds typically seek to provide a return commensurate with equity markets but with less volatility.
- Event-Driven – Focus on corporate events such as mergers or liquidations. This is a catalyst-driven approach, in which a specific event is expected to result in returns that are uncorrelated to the market.
- Relative Value – Focus on the pricing between two or more related securities. Market Volatility can frequently lead to mispricings or dispersion between correlated assets. Relative Value funds seek to capitalize on this dispersion by betting that correlations will normalize. Return objectives will vary depending on the Fund. While Relative Value funds can seek equity-like returns with low volatility, investors are increasingly looking towards the strategy as a fixed income replacement strategy. Investors expect these strategies to be uncorrelated with traditional markets.
- Macro – Focus on the global markets, such as interest rates and currencies, and invest based on a view of geopolitical events. Macro strategies can take directional views on asset prices or be relative value in nature. Macro strategies can seek an equity-like return, but investors look to these funds to generate uncorrelated returns. Furthermore, investors hope these funds can provide downside protection or even positive returns in environments when traditional markets such as stocks or bonds come under stress.
- Multi-Strategy – Focus on creating one fund with multiple underlying portfolio managers to execute different investment strategies and manage risk across the different portfolios. Investors in multi-strategy funds hope that by combining a variety of uncorrelated strategies that the Manager will be able to deliver a low volatility return stream.
Return & Volatility
Generally, a hedge fund will disclose its historical track record in a monthly format. Being able to analyze this data allows an investor to better understand how a hedge fund manager has performed in the past and thus make informed investment decisions. However, it’s important to note that this information is generally produced with a lag and portfolio transparency can remain limited. A portfolio manager’s track record is important, but always remember, past performance is not indicative of future performance.
Time-weighted return - Performance metric generated by a fund over a specified time period independent of the flows into and out of the fund. The time-weighted return is used to calculate what the value of $1 invested at the Fund’s inception is worth today.
Managers often report their performance as time-weighted return, which is typically disclosed as Gross and Net.
- The gross return is the performance return earned by the fund before fees are deducted from performance.
- The net return is the return generated after fees are deducted and can be viewed as the return earned by the investor.
Volatility – The variation of returns over a specified time period, also reported as the standard deviation of returns. This will indicate how much a manager’s returns vary over a specific period. For example, a fund with low volatility will typically show more stable performance across market cycles.
After evaluating the return expectations and risk profile of the investment, it’s critical to understand how the fees are assessed.
There are two main types of fees assessed by a hedge fund:
Management Fee – This is a fixed fee that is charged as a percentage of assets managed by the manager.
Example: If an investor has an average balance of $1,000,000 with a hedge fund that has a 2% management fee, the annual fee charged to the investor is $20,000.
Performance Fee – This is a variable fee and is assessed based on the fund’s performance. Performance fees incentivize portfolio managers to generate excess returns and help attract the top investment talent to the industry. The performance fee is usually based on the fund’s high-water mark or hurdle rate.
- High-Water Mark: This is the peak in value that an investment fund has reached. This ensures the manager does not get paid for poor performance. If the fund loses money over a period, the manager must get above the high-water mark before receiving future performance fees.
& Why Does it Matter to
Take note that this is not an exhaustive list of fees and expenses and it’s important to understand and seek complete disclosure of fees and expenses before making an investment.
Source: Investopedia, December 2020. “High-Water Mark Definition (investopedia.com)”
There is no shortage of hedge fund terminology. However, by understanding the basics, you can better navigate the world of hedge fund investing.
Alternative investing is not without its unique risks and complexities, which makes partnering with the right alternative investment platform paramount. Make sure to stay tuned for Part 2 of our Hedge Fund Terminology series.
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