Glossary - Hedge Funds

(Prepared by Hong Kong Investment Funds Association)

Note: The glossary only represents general observations. Investors should read the prospectus and other relevant documents before they subscribe into a fund.

Absolute return Aggressive growth Alpha Alternative investment Arbitrage
Authorized funds Baby funds Benchmarks Beta Black-Scholes
Call option Calmar ratio Capital guaranteed hedge funds Convertible bond arbitrage Correlation
Distressed securities Domicile Downside deviation Due diligence Efficient frontier
Emerging markets Event driven/Special situations Fixed income arbitrage Fund of Hedge Funds Hedge
Hedge fund Hedge Funds Guidelines High-on-high basis High yield
 
Hurdle rate
Leverage Leverage ratio Limited liability Long position Long/short equity
Macro funds Managed futures Market neutral Market timing Maximum drawdown
Merger arbitrage Offshore funds Performance fees Prime broker Put option
Redemption Redemption notice period Sharpe ratio Short position Short selling
Single strategy hedge fund Sortino ratio Standard deviation Stock lending Total return
Traditional fund Value Volatility    

 

Absolute return
The objective is to achieve a positive level of return and the return is not related to or benchmarked to any indices.

Aggressive growth
An investment strategy that focuses on investing in stocks, which the fund manager expects will experience substantial growth in earnings per share in the near term. The companies in question are generally small or mid capitalization in size.

Alpha
A numerical value indicating excess rate of return relative to a benchmark.

Alternative investment
An investment that has a low statistical correlation of its risks and returns with traditional investments such as stocks or bonds. 

Arbitrage
An investment strategy that aims to exploit market inefficiencies as reflected in price discrepancies between same or related securities. For example, a fund manager may simultaneously purchase and sell similar or identical securities at different prices to yield profits.

Authorized funds
Funds that have been approved by the Securities and Futures Commission to be marketed to the general public in Hong Kong.

Baby funds
Baby funds are the underlying funds in which a fund of funds invests.

Benchmarks
Benchmarks are well-established and commonly used indices (or group of securities) that seek to be representative of the markets in which the securities trade. In other words, a benchmark is a proxy for an investible universe. For example, the S&P 500 is a widely used benchmark for US equities. To a certain extent, a benchmark can give you an indication of the value-added brought by the fund manager. 

A traditional unit trust/mutual fund focuses on outperforming a relevant benchmark whereas a hedge fund tends to focus on achieving an absolute return in all market conditions.

Beta
Beta is a historical measure of an investment's sensitivity when compared to a benchmark. It represents the percentage change in a fund's value for each 1% change in the fund's benchmark. If the beta is more than 1, the investment typically moves (which can be up or down) more than the benchmark. Generally, the higher the correlation is between the investment and its benchmark (as measured by R-squared), the more meaningful the measure of beta.

Black-Scholes
An options valuation model developed by Fisher Black and Myron Scholes in 1973. It is one of the most widely used option pricing models used to determine the fair market value of an option. In valuing an option it takes into consideration the price of the underlying security, the exercise price of the option, the risk free interest rate, the time to maturity of the option and the standard deviation of the underlying asset/security price.

Call option (or "call")
A call option is an option that gives the holder the right, but not the obligation, to buy the underlying security usually at a pre-determined price.

Calmar ratio
A ratio that calculates the average annual return of a fund for a period of time divided by the maximum drawdown during that period. 

Capital guaranteed hedge funds
A capital guaranteed hedge fund is a hedge fund that guarantees the return of capital to investors, subject to the fulfillment of certain conditions. Under the SFC Guidelines on Hedge Funds, hedge funds with a 100% capital guarantee will not be required to impose any minimum subscription (individual fund houses may set a minimum). 

Convertible bond arbitrage
An investment strategy that seeks to arbitrage the discrepancy in price that sometime appears between a company's convertible bonds (or preferred stock) and the same company's equities. Typically a convertible bond arbitrage manager would purchase the convertible bond (or preference share) and sell the equity to try and capture the spread between the prices of the two securities. This strategy usually relies on the ability of the fund manager to convert the convertible bond into a pre-specified number of shares. Convertible bond arbitrage is a relatively conservative investment style amongst hedge funds. The style focuses on returns with low or no correlation to the market.

 Correlation 
Correlation is a measurement of the relationship between two variables. It may denote the movement in the value of a fund against its benchmark. Correlation coefficients range between +1.0 to -1.0. Assets with a correlation of +1.0 consistently move in the same direction as the underlying benchmark and vice versa for -1.0. A correlation of zero means the assets are unrelated. 

Distressed securities
Distressed securities are securities of companies undergoing reorganization such as a reorganization that results from a bankruptcy. Fund managers specializing in distressed securities investment typically buy the securities of a company at a low, or distressed, price in anticipation that the securities will appreciate when the company emerges from the distressed situation. 

Domicile
The country or jurisdiction under which the fund is incorporated.

Downside deviation
Downside deviation measures the variability of returns below a target return or benchmark. For hedge funds that have an absolute return focus, this can be the average negative return over a specified period.

Due diligence
The process of which a fund and its management company is subject to when a potential investor tries to evaluate a fund for investment. This normally involves one or more interviews with the fund manager, understanding the investment strategy and process undertaken by the fund, and a complete review of the offering documentations and the fund structure. 

Efficient frontier 
A graphical representation of both the level of risk and the level of return for any given asset or combination of assets. The efficient frontier is often used to show adding assets to an existing portfolio might change the risk and return characteristics for that portfolio. 

Emerging markets
An investment strategy in which the fund manager specializes in investing in equity securities or fixed income securities of companies in the global emerging markets such as India, Indonesia, etc. This investment strategy tends to have a higher correlation to the underlying securities markets since many of the countries do not permit the short sale of securities in their markets.

Event driven/Special situations
An investment strategy that capitalizes on investment opportunities arising from individual events or special situations that result in short term mispricing of securities. For example, a merger arbitrage fund is an example of an event driven strategy because it relies on an event (in this case, the merger). Fund managers tend to take long positions in positive situations and short positions in negative situations.

Fixed income arbitrage
An investment strategy that takes advantage of possible mispricing/distortions in prices of two similar fixed income securities. Typically, the fund manager tracks the relationship between the yield of various fixed income securities and invest when the relationship gets out of line. Various fixed income instruments such as US Treasury bonds, corporate bonds, mortgage backed securities, derivatives, etc. are used.

Fund of Hedge Funds (FoHFs)
A diversified portfolio that generally invests in single hedge funds managed by different fund managers and have different investment strategies.

The SFC's Hedge Funds Guidelines require that a FoHFs must invest in at least five underlying (or baby) funds, with not more than 30% of its total net asset value invested in any single underlying fund.

Hedge
An investment technique that aims to offset or mitigate investment risk associated with market movements. For example, a fund manager may seek to hedge the risk of adverse market movements on a portfolio of securities by shorting securities or an index (say through futures or options). 

Hedge fund
A wide range of investment funds that seeks to make investment gains that are not related to movements in the markets of the underlying securities in which the fund invests. 

Hedge Funds Guidelines
The Hedge Funds Guidelines published by the Securities and Futures Commission ("SFC") have become effective in May 2002 and been incorporated into the Code on Unit Trusts and Mutual Funds. The Guidelines set out rules for funds seeking authorization as hedge funds.

High-on-high basis
This refers to the mechanism for computing the performance fee: an investor only pays a performance fee if the investment has appreciated, i.e. the fee will only be paid if the net asset value per unit exceeds the one on which the performance fee was last calculated and paid.

High yield
A strategy where a manager holds low credit quality fixed income instruments to enjoy both the high yields offered by such instruments and the potential for capital appreciation due to credit improvement.

Hurdle rate
The prescribed rate of return that must be achieved by the fund before a hedge fund manager is permitted to charge a performance fee.

Leverage
An investment technique that involves borrowing money, either to increase the effective size of the portfolio, or in the form of margin purchasing of, for example, futures contracts. Leverage is also known as gearing. Higher leverage usually implies greater exposure, and thus higher risk.

Leverage ratio
The amount of leverage used by a fund as a percentage of the fund assets. For example, if the NAV of a fund is $5,000,000 and it borrows $10,000,000, then the leverage used is 200%. 

Limited liability
Under the Hedge Funds Guidelines, the liability of holders must be limited to their investment in the scheme and this should be clearly stated in the offering document. 

Where the scheme is a sub-fund of an umbrella fund, the SFC requires ring-fencing of assets between the scheme and other sub-funds within the umbrella structure to prevent a spill-over of excess liabilities. 

Long position
It refers to the exposure of a fund that has purchased a security or a futures contract or a call option.

Long/short equity
An investment strategy that seeks to make gains through simultaneous long and short positions in equities or equity derivatives. Long/short equity can be a directional strategy, that is, it exposes the investor to market direction as the fund manager may choose to be have net long positions in markets that they believe will rise in value and net short positions in markets that they believe will fall in value. The focus of these funds may be geographical, such as Asia Pacific including Japan or sectoral, such as in technology. 

Macro funds
An investment strategy that seeks to exploit investment opportunities arising from major changes in global economies. Hedge fund managers that employ this strategy base their investment decisions on changes in countries' economic outlook or policies and invest through such instruments as currency derivatives.

Managed futures
A fund that invests in a diversified portfolio of futures contracts.

Market neutral
An investment strategy that seeks to have no exposure to the movements of a traditional investment market such as a stock market. For example, this can be achieved by both buying and shorting equal weightings in similar (but not the same) securities. Fund managers generally attempt to select long positions in undervalued securities and short positions in overvalued securities.

Market timing
An investment strategy that seeks to shift investment capital from one asset class or security with low expected investment returns to another asset class or security that is expected to have better investment returns. Asset classes used include stocks, bonds, mutual funds and money market funds.

Maximum drawdown
It refers to the maximum fall in the value of an investment from its highest value to its lowest value before attaining a new high regardless of whether the decline occurred in consecutive months or not.

Merger arbitrage
An investment technique that aims to capture the difference in the price of the shares of two companies involved in a merger or acquisition. The main premise is that once the merger has been consummated, the stocks of the two companies will become the same stock. Fund managers will often buy shares in the target company and sell short those of the acquiring company.

Offshore funds
Funds which are not domiciled in Hong Kong, but in other jurisdictions such as Luxembourg, the Channel Islands, Cayman Islands, Bermuda or Bahamas. The reason for these locations are either because they tend to be tax-free places or places where a fund, once established, can be widely marketed around the world.

Performance fees 
A fee paid to fund managers if the performance of the fund in any one year is above a certain level. Thus if the fund does very well, the manager benefits, giving an incentive to perform. Performance fees are usually charged for funds that invest in very sophisticated instruments, such as hedge funds. Also called incentive fees.

The Hedge Funds Guidelines require that if a performance fee is levied, full and clear disclosure of the calculation methodology should be set out in the fund's offering document.

For fund of hedge funds, the offering document of the scheme must disclose whether a performance fee is levied at both the scheme level and the underlying funds level.

Prime broker
It refers to a financial institution that provides services to a hedge fund, including the provision of clearing, custody, margin financing, reporting and stock lending services.

Under the Hedge Funds Guidelines, the prime broker must be a substantial financial institution subject to prudential regulatory supervision.

Put option (or "put")
A put option is an option that gives the holder the right but not the obligation to sell the underlying security usually at a pre-determined price. 

Redemption
The liquidation or sale of an investment by an investor in a fund that results in the return of the investor's money to the investor.

Redemption notice period
The period of advance notice that many hedge fund managers require from an investor that intends to redeem their investment in a hedge fund. Unlike traditional funds that do not require a notice period, hedge fund strategies often require more time to unwind their positions and raise cash to return to the investor. The notice period gives the hedge fund manager adequate time to plan the liquidation of his investment positions in an orderly fashion. Typically, notification is required in writing.

Sharpe ratio
A risk/reward ratio which compares the rate of return with risks required to achieve that return. The higher the ratio, the higher the risk-adjusted return of the fund.

Short position
In the cash market, it refers to a sale of securities not owned by the investor. The securities sold are borrowed from the owner of the security (who is in turn compensated through the payment interest). In the futures market, it refers to the sale of a futures contract; whereas in the options market, it refers to the position of the option writer.

Short selling
An investment strategy based on identifying overvalued securities and selling these securities in the anticipation of being able to repurchase them at later date at a lower price.

Single strategy hedge fund
A hedge fund that engages in a single strategy or a set of sub-strategies that are similar in nature or that require the same skill-set to manage by its manager. 

Sortino ratio
The Sortino ratio is similar to the Sharpe ratio except that instead of using standard deviation as a denominator, it uses Downside Deviation. The Sortino ratio was developed to differentiate between "good" and "bad" volatility. If a fund is volatile on the upside (that is, there are a lot of big gains), its Sharpe ratio would still be low. However, investors may consider this a "good" thing. By using downside deviation the Sortino focuses on the "bad" volatility only.

Standard deviation
A statistical measurement of the dispersion of a fund's returns from its mean over a specified time period. It describes how widely returns vary. A higher standard deviation indicates a wider dispersion of past returns.

Stock lending
A loan of a security (like a share) from the legal holder to a borrower. The borrower can then sell the stock as if he owned it but remains liable to the lender for all of the benefits of the stock (such as dividends, etc.). Additionally, the borrower usually pays the lender interest on the value of the stock borrowed. The borrower's strategy is based on his belief that the value of the share will fall below the price at which he is able to sell. This will give him an opportunity to repurchase the share at a lower price to give it back to the lender and allowing the borrower to profit from the difference.

Total return
It is a measure of a fund's investment performance over a specific period of time including reinvested dividends and capital appreciation.

Traditional fund
An investment fund whose return characteristics are tied closely with the return profile of the traditional asset classes that the fund invests in or benchmarked against. For example, a Hong Kong Equity Fund may have a return and risk profile very similar to that of the Hang Seng Index.

Value
An investment strategy that focuses on purchasing securities of companies which are perceived to be selling at a discount to their intrinsic potential worth, or "undervalued", possibly because the company is out of the favor of the market or analysts. Fund managers believe that investments will appreciate as the market recognizes the "value".

Volatility
A measure of the degree of dispersion of its investment returns. Volatility is usually measured as standard deviation. It is used to estimate the risk of a fund. It is usually assumed that funds with higher volatility also have higher risk.


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