Glossary of common terms
Accredited investor - An institution or high-net worth individual, to whom securities may be promoted pursuant to a private placement in reliance on the “safe harbour” provision found in Regulation D of the US Securities Act of 1933 and defined as one of the following: (1) a bank, insurance company, registered investment company, business development company, or small business investment company; (2) an employee benefit plan, a charitable organization, corporation, or partnership or a trust not formed to acquire the securities offered with assets exceeding $5 million; (3) a director, executive officer, or general partner of the company selling the securities; (4) a business in which all the equity owners are accredited investors; (5) a person who has individual, or joint net worth with the person’s spouse, exceeding $1 million; or (6) a person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000.
Alternative investment - The essential defining features of alternative investments are: (1) the pursuit of absolute return – that is, the quest to achieve a positive return regardless of whether asset prices are rising or falling; (2) freedom to trade all asset classes and a wide range of financial instruments while employing a variety of investment styles, strategies and techniques in diverse markets, and (3) reliance on the investment manager’s skill and application of a clear investment process to exploit market inefficiencies and opportunities with identifiable and understandable causes and origins. Alternative investment managers may take advantage of pricing anomalies between related securities, engage in ‘momentum’ investing to capture market trends, or utilise their expert knowledge of markets and industries to capture profit opportunities that arise from special situations. The ability to use derivatives, arbitrage techniques and, more importantly, short selling - selling assets that one does not own with the expectation of buying them back at a lower price – affords alternative investment managers rich possibilities to generate growth in falling, rising and unstable markets.
Asset allocation - The structure of a portfolio - namely the allocation of specific portions of it across different assets classes, i.e. securities, property, cash, fixed interest, etc.
Assets under management - Includes all investments, including cash, which are managed and administered by a fund manager for itself and its customers.
Diversification - Refers to a strategy of including a group of investments in a portfolio that are dissimilar to each other, so that the combined effect of their inclusion results in the greater likelihood that the portfolio’s goals will be achieved - compared to the likelihood of doing so with a portfolio of similar investments.
Downside risk - Downside risk is a similar measure to Volatility, except that this statistic calculates an average return for only the periods where return was lower than zero (or another benchmark rate) and then measures the variation of only these "losing" periods around the calculated average. In other words, this statistic measures the volatility of the downside performance.
Hedge fund - There is no standard international/legal definition though they may have all or some of the following characteristics: May use some form of short asset exposure; may use derivatives and/or more diverse risks or complex underlying products are involved; and may use some form of leverage. Funds charge a fee based on the performance of the fund as well as a management fee; investors are typically permitted to redeem their interest only periodically, e.g. quarterly or semi-annually; typically, the manager is a significant investor alongside other (outside) fund investors.
Hedge fund of funds - A fund whose underlying investments are in other hedge funds. Sometimes also known as multi manager funds.
Hedging – The process of protecting the value of an investment from the risk of loss in case of an adverse price movement.
High water mark - The existence of the high water mark ensures that a fund only takes performance-related fees on new profits. For example, assume a $1,000,000 investment is made and that the fund declines by 20% in year 1, leaving $800,000 in the fund. In year 2, the fund returns 25%, bringing the investment value back to $1,000,000. If the fund employs a high water mark, it will not take incentive fees on the return in year 2, since the investment has never really grown, i.e. the fund did not make any new profits. The fund will only take incentive fees if the investment grows above the level of $1,000,000.
Investment strategy - The particular investment process employed by a manager in the application of an investment style. Generally there are about 20 primary strategies employed by hedge funds, such as Global Macro and Long-Short Equity.
Leverage - The borrowed money that an investor employs to increase buying power and increase its exposure to an investment. Users of leverage seek to increase their overall invested amounts in the hope that the returns on their positions will exceed their borrowing costs. The extent of a fund's leverage is stated either as a debt-to-equity ratio or as a percentage of the fund's total assets that are funded by debt. Example: If a fund has $1 million of equity capital and it borrows another $2 million to bring its total assets to $3 million, its leverage can be stated as "two times equity" or as 67% ($2 million divided by $3 million).
Liquidity - The ease with which an investment product/fund can be sold/redeemed from, without impacting its price. Hedge funds typically offer quarterly or annual liquidity, meaning that they allow investors to redeem their shares that often.
Management fee - A fee paid to a fund manager for managing and providing services to the fund as well as to cover certain operating expenses. Investors are typically charged separately for costs incurred for outsourced services. The management fee is generally expressed as a charge against investor assets and typically ranges from an annual 0.5% to 2% of an investor's entire holdings in the fund, and usually collected on a quarterly basis.
Net asset value - The market value of a fund's total assets, minus its liabilities and intangible assets, divided by the number of its shares outstanding. The measure is used to determine prices available to investors for redemptions and subscriptions. Hedge funds typically calculate their NAVs at the end of every business day, but report them to investors on a monthly basis. Mutual funds report their NAVs daily.
Performance fee - A fee paid to a fund manager for providing returns on an investment, often by reference to a benchmark or Hurdle rate. This fee is based on net new profits and is earned by the hedge fund manager for the period concerned. It may be paid annually or quarterly but accrues monthly in the fund valuation.
Redemption - Liquidation of shares or interests in an investment fund.
Risk-adjusted performance - Risk relative to return: the return achieved per unit of risk or the risk associated with a particular level of reward, typically represented by the Sharpe ratio. Improving the risk-adjusted return depends either on increasing returns without a commensurate increase in the level of risk, or maintaining the level of returns whilst lowering the associated risk.
Short selling - The selling of shares in anticipation of being able to buy them back in the future at a lower price. A manager who sells short estimates that the securities, or the market, are overvalued or anticipates earnings disappointments, often due to accounting irregularities, new competition, change of management etc. Funds that sell short are often used as a hedge to offset long-only portfolios and by those who feel that the market is approaching a bearish cycle. Funds that sell short also are by nature strongly exposed to extreme risks since their short positions present infinite loss potential. As a result, short selling is strictly regulated and should be regarded with caution. Short selling is a directional strategy generally characterized by relatively volatile returns and a significant correlation with major stock indexes.
Systemic risk - The risk that a default by one market participant will have repercussions on other participants due to the interlocking nature of financial markets. For example, Customer A's default in X market may affect Intermediary B's ability to fulfil its obligations in Markets X, Y, and Z.
Value-at-risk - A measure of the potential change in value that a fund's portfolio may experience. It is usually expressed as a percentage, which is referred to as a confidence level.