Hedge Fund Terminology: Part 2

Managers utilize unique hedge fund terminology when discussing their portfolio exposures and past performance. Several widely used metrics can help tell a story about a fund’s track record.

Being able to understand and interpret these concepts provides for a better insight into how the hedge fund portfolio is constructed and how the exposure can best support an existing portfolio.

Beta – Is a measure of the exposure that an asset (or in this case Fund) is expected to give you to another asset. For example, when people talk about Beta they are generally comparing how much a certain asset is expected to move relative to the S&P 500.

Example: A stock with a beta of 1.5 would indicate that if the S&P 500 returned 1% over a time period, then that stock would deliver a return of 1.5%, holding all other factors constant.

Correlation – This measures the degree to which an investment moves in the same direction as that of the asset to which it is being compared. Correlation and beta are frequently confused with one another. A key difference between the two is that correlation is bounded from -1 to 1, while beta is unbounded (such as in the example above). Assets that have a correlation of 1 being perfectly correlated, while assets with a correlation of -1 have a perfectly negative correlation.

Sharpe Ratio – This is a measure of risk-adjusted returns and details how much return a manager is earning for each unit of risk. The ratio is calculated by subtracting the risk-free rate from the expected return of the investment and dividing by the standard deviation of returns.

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Generally, a hedge fund with a Sharpe ratio greater than 1 would indicate that the fund is delivering more than one unit of return for each unit of risk being taken.

Sortino Ratio – This measures downside volatility and is best used for evaluating investments with relatively high tail risk. This ratio is calculated by subtracting the risk-free rate from the expected return of the investment and dividing by the standard deviation of returns below a specified minimum target.

Max Drawdown – This metric is best classified as the percent decline in value of a fund from peak to trough. This data point provides insight into the largest percent decrease that occurred during the life of the fund. This can also be produced for a certain period (i.e., max drawdown during the first quarter of 2020).

Exposure – The exposure can be reported as gross exposure and as net exposure. The gross exposure is the percentage of capital invested long plus the percentage of capital invested short. The net exposure is long exposure minus short exposure.

The exposure data informs an investor as to how much, if any, leverage the manager is taking and whether the Fund is Net Long or Net Short.

Attribution – Attribution data provides information on the sources of returns for the Fund. The attribution data informs an investor as to which securities or asset classes are either contributing or detracting from performance.

After evaluating the performance and portfolio composition but before making an investment, it's essential to understand the liquidity terms. This information will always be provided by a hedge fund and is a very important bit of information.

The liquidity terms will often include the following information:

Lock Up - How long the investor must remain with the fund before a redemption request can be submitted, e.g. if a lock-up is one year, an investor must wait one year before submitting a redemption request.

Redemptions – Similar to subscriptions, an investor can submit a redemption request pursuant to the applicable terms to have the funds wired back to the investor’s bank account.

Redemption Frequency - How often a fund meets redemption requests, which are usually monthly, semi-annually, or annually.

Redemption Notification – How much time is needed before a redemption request can be honored, e.g. if a fund offers quarterly liquidity with one month’s notice, an investor must submit their redemption at least one month before the quarter-end.

Investor Level Gate - Max percentage an investor can take out of their existing position at the time of redemption, e.g. if a fund has a 25% investor level gate with redemptions being each quarter and an investor submits a full redemption, the investor will be fully redeemed after one year, receiving 25% of their position each quarter.

Fund Level Gate - the max percentage a fund will allow in redemptions over a given time period. Redemptions from the Fund will be halted if the percentage of assets redeemed by all investors in the Fund is more than the fund level gate. Going with the example above, if a fund has quarterly redemptions with a 25% Fund level gate and an investor submitting a full redemption, the investor will receive their total proceeds, if the total amount of redemptions from other investors does not exceed more than 25% of the fund.

There is no shortage of hedge fund terminology. However, by understanding the basics, you can better navigate the world of hedge fund investing. And each of the concepts discussed can be applied differently with each manager, making it vital to read and understand all disclosure documents prior to making an investment.

Alternative investing is not without its unique risks and complexities, which makes partnering with the right alternative investment platform paramount.