Glossary of Terms
40 Act
This is a generic term that usually refers to the Investment
Company Act of 1940, which regulates investment companies such as
mutual funds, exchange traded funds and closed end funds. The Act
requires that funds meet certain rules and requirements in order to
be eligible for sale to the public.
Absolute return
This term can have several meanings. In its broadest sense, it
is the measure of the gain or loss in the value of an asset. In the
sense of alternative strategies, an "absolute return" strategy
seeks to provide positive returns regardless of the overall return
of the market. "Absolute return" can also sometimes refer to the
entire universe of hedge funds that subscribe to such
strategies.
Accredited Investors
This term, used by the SEC, refers to financially sophisticated
investors. Because these people have much higher-then-average
wealth, they are assumed to understand more about finance and
investments, and thus have a reduced need for certain regulatory
protections. Qualifying as an "accredited investor" requires
meeting one of the following criteria:
- Earn an individual income of more than $200,000 per year, or a
joint income of $300,000, in each of the last two years and expect
to reasonably maintain the same level of income.
- Have a net worth exceeding $1 million, either individually or
jointly with his or her spouse.
- Be a general partner, executive officer, director or a related
combination thereof for the issuer of a security being
offered.
Asset Allocation
The process of apportioning portfolio holdings among different
types of assets (e.g., stocks, bonds, industry sectors, individual
securities, alternative investments). The asset allocation process
generally aims to balance risk and reward, according to an
individual's goals, risk tolerance and investment time horizon.
Alternative asset
Alternative "assets" are those that typically fall outside the
equity and bond markets, for example: real estate, private equity,
and commodities. Sometimes alternative assets are also called "hard
assets" or "real assets," as they are often tangible items that
hold inherent value-that is, their value is not derived from other
sources.
Alternative investments
Generally an investment that is not one of the tree traditional
asset types (stocks, bonds, and cash). It is important when
considering alternatives to know whether the investment in question
is an alternative "asset" or alternative "strategy," or a
combination of both.
Alternative strategies
Alternative strategies have more flexibility in the way they use
assets in the portfolio, including such tactics as shorting,
leverage, and using derivatives, such as futures, forward
contracts, options and swaps. Within the portfolio, alternative
"strategies" can use both traditional assets (like equities and
bonds) and/or alternative assets like commodities and private
equity.
Arbitrage
This is the practice of exploiting price differentials in two or
more markets - i.e., buying an asset in one market and selling it
in another market where the price is higher. By pairing two or more
transactions, the manager can essentially profit from the price
spread between markets.
Bear market
Generally considered a broad market condition in which the
prices of securities are falling. Most bear markets coincide with
periods of economic difficulty and widespread pessimism. In some
cases, negative sentiment can lead to self-sustaining declines in
economic activity and market performance.
Bond
A debt instrument issued by an entity (e.g., a corporation or
government institution), which has borrowed money from investors at
a fixed interest rate for a defined period of time. The "bond"
instrument defines all the relevant terms of the of the loan -
e.g., time period, rate of interest, restrictions (e.g.,
pre-payment penalties).
Bull market
Generally considered a broad market condition in which the
prices of securities are rising and expected to continue to rise.
Most bull markets coincide with a period of economic expansion, or
with the prospect of a near-term positive trend (i.e., the end of a
recession). In some cases positive sentiment can lead to
self-sustaining advances in asset prices and economic activity.
Chicago Board of Exchange (CBOT)
The world's oldest futures and options exchange, which was
established in 1846. CBOT is part of the publicly held CME Group,
which also operates the NYMEX and COMEX exchanges. www.cmegroup.com
Commodity
A "hard asset" that is a basic good used in commerce. Examples
of different commodities include: agricultural commodities (e.g.,
corn, soybeans, pork bellies); metals (e.g., gold, silver); energy
(e.g., oil, natural gas); and other natural resources (e.g.,
timber).
Convertible arbitrage
This is a market-neutral strategy that seeks to profit from the
difference between the value of a company's common stock and the
value of preferred securities that are convertible to common stock.
Sometimes the value of the stock versus the value of convertible
securities is out of synch, which may allow a manager to make a
profit by buying the convertible shares while selling short the
common shares at the same time. The short sale against the long
position in the convertible security, the investor essentially
isolates the embedded option in the convertible security. The
investor then benefits from any increase in volatility, which would
cause the option to increase in value.
Convertible securities
These can be either convertible shares (equity) or convertible
bonds (debt). Convertible equity is commonly known as "preferred
shares," which pay a dividend like a bond and often have
convertibility into common stock under certain conditions;
preferred shares generally do not have voting rights. A convertible
bond is similar in that it has a convertibility feature, but the
instrument itself is a debenture - i.e., a debt - and as such has
debt-like features (e.g., callable). Convertible securities
generally have an embedded "option" that gives the holder the right
to exchange the security for common shares under certain conditions
and at a certain prices. It is this option feature that
arbitrageurs ("arbs") seek to exploit in convertible arbitrage
strategies.
Correlation
This is a measurement of how closely the performance of two
assets match each other - the measure of correlation ranges from
positive one (1) to negative one (-1). For example:
- If the value of two assets always moves in the same direction,
they are said to be "highly correlated," and they have a
correlation of positive one (1).
- If their values always move in opposite directions, they are
said to have a "negative correlation" or "inverse correlation," and
have a correlation of negative one (-1).
- If there is no consistent mathematical relationship between the
value of the two assets, then the correlation coefficient is
0.
Counterparty
In broad terms this is a party to a contract. It can be a person
or an entity. In alternatives, a counterparty is usually an
institution that is buying or selling an investment contract.
Counterparty Risk
This is the risk that a counterparty will not have the means to
satisfy its obligations under a contract. In alternatives,
counterparty risk usually applies to derivatives contracts - i.e.,
that the buyer will have not sufficient capital to complete a
purchase or a seller will not be able to deliver the promised
security or payment upon settlement of the contract.
Dedicated Short-Bias
A hedge fund strategy with which the fund manager takes more
short positions than long positions.
Derivatives
A security whose price is dependent upon, or derived from, one
or more underlying assets. For example, a "future" is a contract in
which the contract buyer agrees to purchase a specific asset, at a
specific time, at a specific price from the contract seller (the
counterparty). An "oil future" would obligate the buyer to purchase
oil at a certain price, at a certain time, from the contract
seller. Such contracts are considered securities and are called
"derivatives," and they have market value. Derivatives of all kinds
can be bought, sold or traded on open exchanges, such as the
CBOT.
Discretionary
These strategies rely primarily on manager insight and judgment
in security selection and portfolio positioning. Managers may use
mathematical models and other analytical techniques to supplement
their decision making, but the primary driver of decision making is
the manager's judgment. (see also "Systematic")
Diversification
This is an investment strategy in which the investor makes
allocations across a wide number of assets within a single
portfolio, with the goal of smoothing out extreme fluctuations in
the portfolio's value (i.e. "volatility"). The objective is for
positive performance in some investments to neutralize negative
performance in others, keeping the portfolios overall performance
(return and volatility) within a narrow target range. According to
Modern Portfolio Theory, the larger the number of assets across
which the portfolio is diversified, the lower the portfolio's
volatility should be, and the higher the probability of meeting the
return objective.
Efficient Frontier
A line created on a risk-reward graph, where risk is on the
vertical axis and return is on the horizontal axis. For any given
combination of assets, investors can plot the portfolio allocations
that are the most efficient, defined as providing the highest
expected return possible for a given amount of risk. The line on
the graph that connects all these "efficient" portfolios is called
the "efficient frontier."
Equity
In investing, is typically considered to be ownership interest
in a corporation in the form of common stock or preferred
stock.
Event Driven
These are hedge fund strategies in which the manager seeks to
profit from price inefficiencies caused by company-specific news or
events - e.g., merger announcements, bankruptcies, restructurings,
spin-offs, distressed credit or equity situations, asset sales.
Exchange Traded Fund (ETF)
These are investment vehicles traded on stock exchanges, much
like stocks. An ETF holds assets such as stocks or bonds and trades
at approximately the same price as the net asset value of its
underlying assets over the course of the trading day.
Exposure
This is the amount an investor has "at risk" in the chosen
investment - i.e., the amount he/she can lose.
Fixed income arbitrage
This type of hedge fund strategy seeks steady returns with low
volatility, by exploiting inefficiencies in fixed income markets.
Managers can use interest rate swaps and other strategies, and
exploit mis-pricings of both public- and private-sector debt.
Futures
These are a type of derivative. A "future" is a financial
contract that obligates the buyer to purchase an asset, such as a
physical commodity or a financial instrument, at a predetermined
future date and price. "Futures" are traded on exchanges such as
the CBOT, NYMEX, or COMEX.
Global Macro
These are hedge fund strategies that use derivatives to capture
potential returns in global markets. The manager may invest in a
wide range of instruments and asset classes based on a view about
how systemic influences (e.g., interest rates, governmental
policies, fund flows) may affect given markets or asset prices
around the world.
Hedge
This is a strategy by which the investor makes tries to reduce
the risk of adverse price movements. Hedge strategies are often
implemented using derivatives such as futures, swaps and
options.
Hedge Funds
An investment portfolio that can use advanced strategies such as
leveraged, long, short and derivative positions with the goal of
generating consistent returns (either in an absolute sense or over
a specified market benchmark). There are several key types of hedge
funds, and individual funds can vary widely in structure,
investment approach and objective.
Institutional Investors
These can be ultra-wealthy individuals, incorporated entities
(including for-profit, not-for-profit organizations) or public
agencies that trade securities. Institutional investors are large
enough, and their trading volume is large enough, to qualify them
for preferential treatment and lower commissions. They are also
generally considered more expert in finance and investment, and
thus qualify as "accredited investors." The most common types of
institutional investors are public and private pension funds,
endowments, and foundations.
Leverage
This is a strategy in which the investor seeks to increase
potential return of an investment through the use of borrowed
capital.
Limited Partnership
This is a legal structure that is established by two or more
partners to conduct a business jointly. In this structure one or
more of the partners is liable only to the extent of the amount of
money that partner has invested - the partners are not personally
liable for the obligations of the Partnership.
Liquidity
There are different types of liquidity:
- "Market liquidity" is the degree to which an asset or security
can be bought or sold in the market without affecting the asset's
price. Highly liquid assets and securities can be easily bought and
sold; "illiquid" assets are those that are generally considered
difficult to buy or sell, either because of a lack of demand, a
lack of supply, or because of contractual restrictions on their
purchase/sale.
- "Fund liquidity" is generally considered the degree to which a
fund has sufficient cash on hand to satisfy investor withdrawals;
or the ease with which the fund could raise sufficient cash if
required to.
Liquidity Risk
This risk is usually discussed in terms of investment funds or
managers. It is the risk that the fund or manager will not have
access to sufficient capital to meet cash demands - to meet
investor withdrawals, operating expenses, or other
requirements.
Long/Short
This is a hedge fund strategy that combines two equity
investment strategies: a) buying a stock the manager likes and
holding it until the manager decides to sell (buying "long"); and
b) borrowing a stock the manager does not like and selling it, with
the goal of buying it back later at a lower price and returning it
to the lender (selling "short"). In a short sale, the difference
between the sale price and re-purchase price is the profit on the
trade.
Long Only
These are portfolios in which the manager holds only "long"
positions - i.e., assets bought at market value and held until the
manager decides to sell, hoping to capture any increase in
value.
Managed Futures
This strategy involves building a portfolio of futures contracts
- with the freedom to take both "long" and "short" positions.
Managed futures portfolios can buy and sell futures in a number of
areas, such as commodities and financials, including interest rates
and currencies.
Market Exposure
This term refers to the types and levels of investment a manager
may have in specific markets or sectors. Market exposure can be
discussed in different ways. For example, any portfolio that
contains stocks has "exposure" to equity markets. A portfolio that
contains 10% non-U.S. stocks is said to have a 10% "international
exposure." In alternatives, market neutral strategies are said to
have "no market exposure" if they can achieve zero correlation to
equity market indexes - that is, their performance is not affected
by whether the broader market goes up or down.
Market Maker
This refers to an individual or entity that both buys and sells
securities or commodities. In finance, market makers are generally
institutions that hold securities or commodities in inventory,
buying and selling with a goal of making a profit from the spread
between those prices.
Market Neutral
In this strategy, a manger does not take a position on whether
the market will go up or down, and indeed seeks to avoid "market
exposure" altogether. The overall portfolio is not "long" the
market - i.e., positioned to profit if the market goes up. The
portfolio is also not "short" the market - i.e., positioned to
profit if the market goes down. Generally, market neutral
strategies seek to capture increasing values in specific assets or
groups of assets while maintaining a neutral position to the market
overall - i.e., a zero correlation between the portfolio and the
market.
Momentum
Momentum refers to the rate of acceleration of a security's
price or volume. It can also refer to "momentum strategies" in
which the investor uses price momentum as the primary criteria for
selecting securities for the portfolio.
Multi-strategy
These are hedge funds that can use many alternative strategies
all within a single portfolio - e.g., strategies like short-bias;
global macro; event driven. The manager's goal is to diversify
across strategies in order to help smooth portfolio returns, the
same way traditional a manager may diversify across assets.
Options
These are derivative securities. An "option" is a contract sold
by one party (option writer) to another party (option holder), in
which the option holder has the right to purchase an asset at a
given price for a specified period of time. The option holder may
execute the deal according to the contract terms, but is not
obligated to do so. (Unlike a futures contract in which both
parties are obligated to make the purchase/sale according to the
contract terms on the specified date.)
Private Equity Firms
In private equity, the investor or fund makes a direct
investment into a private company, or conducts a buyout of a public
company by purchasing all outstanding shares and "taking it
private," which results in a delisting of that company's stock.
Qualified Clients
As defined by the SEC these are investors who meet one of the
following criteria:
- A person or company with at least $750,000 under the management
of the investment adviser at the time of entering into a contract
with the adviser
- A person who or company that the investment adviser (and any
person acting on his behalf) reasonably believes, immediately prior
to entering into the contract, either:
- Has a net worth (together, in the case of a natural person,
with assets held jointly with a spouse) of more than $ 1,500,000 at
the time the contract is entered into; or
- Is a qualified purchaser as defined in section 2(a)(51)(A) of
the Investment Company Act of 1940 at the time the contract is
entered into; or
- A natural person who immediately prior to entering into the
contract is:
- An executive officer, director, trustee, general partner, or
person serving in a similar capacity, of the investment adviser;
or
- An employee of the investment adviser (other than an employee
performing solely clerical, secretarial or administrative functions
with regard to the investment adviser) who, in connection with his
or her regular functions or duties, participates in the investment
activities of such investment adviser, provided that such employee
has been performing such functions and duties for or on behalf of
the investment adviser, or substantially similar functions or
duties for or on behalf of another company for at least 12
months.
Real Estate Investment Trusts (REITs)
This is a tax designation designed to provide real estate
investors with a similar legal structure that mutual funds provide
for stock and bond investors. REITs can be publicly or privately
held; the shares of public REITs trade on major exchanges like
other securities. REITs invest in real estate, either by buying
properties directly or by financing mortgages.
Rebalancing
This is the process by which an investor realigns the weightings
of assets in a portfolio. The process involves periodically buying
or selling assets to maintain desired levels of asset
allocation.
Replication
These strategies attempt to reproduce the return performance of
hedge funds (i.e., "replicate") without using typical hedge fund
portfolio approaches - e.g., shorting, leverage. Managers of these
strategies are seeking to provide inexpensive, transparent, more
liquid ways of delivering hedge fund-like performance to
investors.
Risk
This is the chance that an investment's actual return will be
different than expected. There are many different metrics for
portfolio risk. The most common proxy for risk is portfolio
volatility. Though newer metrics focus on other measures such as
Value at Risk.
Short Position
This refers to an investor's holding of a borrowed equity when a
short selling transaction is undertaken.
Short Selling
In short selling, the investor seeks to profit from the decline
in the price of a security. To implement a "short" strategy, the
investor borrows the target security and sells it at the market
price. The investor's goal it to buy it back later once the market
price has dropped, and return the security to the lender. The
investor's profit on the transaction is: the income from the
original asset sale, minus the money spent to re-purchase it, as
well as any borrowing cost.
Spot transaction
This is a short-term contract in which two parties agree to a
sale/purchase of a specific currency at a specific price on the
same day or within one or two days.
Standard Deviation
In general, this is a statistical measure of how much the
performance of a given variable fluctuates from its mean
performance. In finance, it is used as a measure of historical
volatility, either in the price of an asset or security, or in the
return performance of an investment (e.g., a fund or portfolio).
The higher the standard deviation, the more frequent the expected
fluctuations from the mean. Thus, a higher standard deviation (a
higher "volatility") is associated with a higher risk that the
investment will not perform as desired.
Swap Agreements
Traditionally, this is the contractual exchange of one security
for another. The swap may be based on features such as the
security's maturity (bonds) or quality (stocks or bonds). Recently,
the use of these instruments has grown to include other types of
securities (e.g., currencies) as well as interest rate swaps.
Systematic
These strategies rely primarily on mathematical models for
security selection and portfolio positioning. Generally, the
manager creates an algorithm that models quantitative features of
market performance (e.g., trading volume, price momentum, earnings,
reversion patterns, historical trading patterns). Based on its
interpretation of market conditions, the model will recommend
optimal portfolio positioning relative to established patterns. The
manager retains discretion over final portfolio implementation, but
the output of the quantitative analysis is generally given primary
consideration. (see also "Discretionary")
Transparency
The extent to which investors have ready access to financial
information. Transparency can apply to companies, funds, or a
manager's investment process, and it applies to multiple issues
such as price levels, market depth and audited financial
reports.
Value at Risk (VaR)
This is a probability risk measure, meaning that it indicates
the probability of losing a specific amount, on a specific asset or
portfolio, over a specific time horizon. For example, a portfolio
that has an annual 2% VaR of $1 million dollars means that this
particular portfolio has a 2% chance of losing $1 million in any
given year. There are multiple varieties of VaR in use for both
risk management and risk measurement. VaR came to prominence as a
risk measure after the market crash of 1987, as a complement to
other statistical models and a systematic method of estimating the
impact of extreme but improbable events.
Venture Capital
An investment strategy that involves private investors taking
private equity stakes in startup and small- and medium-size
enterprises with strong growth potential. Private investors and
institutions can make direct venture capital investments, or they
van invest through "venture funds" managed by professional venture
capitalist investors.
Volatility
A statistical measure of the dispersion of returns for a given
security or market index. Volatility can measured in different
ways: a) measured as standard deviation (or variance) from the mean
returns for that same security or portfolio; or b) measured as
standard deviation from a market index or portfolio other
benchmark. Commonly, the higher the volatility, the riskier the
security.
 
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