The majority of people do not understand exactly what a hedge fund is or some of the common investing terms associated with it….go download a free copy of my book “An American Hedge Fund” HERE and you’ll learn what a startup hedge fund is.
Here is a post to give you a basic rundown of the industry as a whole, sort of like a “Hedge Fund for Dummies.”
First off, according to Investopedia a hedge fund is:
“An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). Legally, hedge funds are most often set up as private investment partnerships that are open to a limited number of investors and require a very large initial minimum investment.” I’ve heard that to invest in SAC Capital, people needed to have at least $50,000 to start.
Download this cheat sheet of 12 important hedge fund terms to know.
“Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year” and they also have specific dates that you are able to take money out. That’s why SAC Capital didn’t see all of the outside money go out on one date, they had certain requirements in terms of drawing out money.
“In the U.S., laws require that the majority of investors in the fund be accredited. That is, they must earn a minimum amount of money annually and have a net worth of more than $1 million, along with a significant amount of investment knowledge. You can think of hedge funds as mutual funds for the super-rich. They are similar to mutual funds in that investments are pooled and professionally managed, but differ in that the fund has far more flexibility in its investment strategies.”
The goal of most hedge funds is to maximize return on investment. The name “hedge fund” is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. Nowadays, hedge funds use dozens of different strategies, so it isn’t accurate to say that hedge funds just “hedge risk.
Now for some of the most common terms:
Absolute Return – the goal is to have a positive return, regardless of market direction. This is the return that an asset achieves over a certain period of time.
Accredited Investor – a term used by the Securities and Exchange Commission (SEC) under a rule known as “Regulation D” to refer to investors who are financially sophisticated and have a reduced need for the protection provided by certain government filings. Individuals, banks, insurance companies, employee benefit plans, and trusts can all be considered accredited investors.
Alpha – the return to a portfolio over and above that of an appropriate benchmark portfolio (the manager’s “value added”). This is where the website “Seeking Alpha” gets its name.
Asset Mix – the classification of all assets within a fund or portfolio. They are assigned to one of the core asset classes: equities, fixed income, cash and real estate. Other categories that are sometimes considered asset classes are commodities, international investments, hedge funds and limited partnership interests.
Beta – a measure of systematic (i.e., non-diversifiable) risk. The goal is to quantify how much systematic risk is being taken by the fund manager vis-à-vis different risk factors, so that one can estimate the alpha or value-added on a risk-adjusted basis. If XYZ has a beta of 1.5, it will supposedly move 1.5 percent for every 1 percent move in the market.
Correlation – a measure of how strategy returns move with one another, in a range of –1 to +1. A correlation of –1 implies that the strategies move in opposite directions and vice versa.
Hurdle Rate – the return where the manager begins to earn incentive fees. If the hurdle rate is 5% and the fund earns 15% for the year, then incentive fees are applied to the 10% difference.
Leverage – this is when someone borrows money to increase their position in a security. If one uses leverage and makes good investment decisions, leverage can magnify the gain. However, it can also magnify a loss. Be careful.
Risk Arbitrage – Investopedia give three types of this: First there is merger and acquisition arbitrage – The simultaneous purchase of stock in a company being acquired and the sale (or short sale) of stock in the acquiring company. Second there is liquidation arbitrage – The exploitation of a difference between a company’s current value and its estimated liquidation value. Lastly there is pairs trading – The exploitation of a difference between two very similar companies in the same industry that have historically been highly correlated. When the two company’s values diverge to a historically high level you can take an offsetting position in each (e.g. go long in one and short the other) because, as history has shown, they will inevitable come to be similarly valued.
Run on the fund – this is when a hedge fund faces a growing amount of redemption requests. SAC experience this earlier in the year.
R-Squared – this is a measure of how closely a portfolio’s performance varies with the performance of a benchmark, and thus a measure of what portion of its performance can be explained by the performance of the overall market or index. Hedge fund investors want to know how much performance can be explained by market exposure versus manager skill since they are most likely paying a large fee to have their money in the fund.
Value at Risk – this is a technique that uses the statistical analysis of historical market trends and volatilities to estimate the likelihood that a specific portfolio’s losses will exceed a certain amount. Value at risk is used by risk managers in order to measure and control the level of risk which the firm undertakes. The risk manager’s job is to ensure that risks are not taken beyond the level at which the firm can absorb the losses of a probable worst outcome.