Glossary

• Absolute Return: Portfolio return without subtracting any benchmark return.
• Active Management: Conducting valuation research and then choosing a portfolio in an attempt to outperform the average investor by overweighting undervalued securities and underweighting (or short-selling) overvalued ones. See Passive Management.
• Active Return: Portfolio return minus the benchmark return.
• Active Risk: Standard deviation of active return. The term is also sometimes used to refer to the difference between the risk exposures of the portfolio and the benchmark.
• Alpha (or Jensen’s Alpha): The average or expected out-performance of an asset or portfolio, adjusted for market risk.
• Historical alpha: (average out performance over an earlier sample period) is called expost alpha, whereas forecast alpha (expected out performance in the future) is called exante alpha.
• Alternative Investments: Broad category of investments, other than stocks and bonds, including venture capital, private equity, precious metals, collectibles, and hedge funds.
• Arbitrage: In theory, profiting by exploitation of mispriced securities while hedging away all risk. In practice, arbitrage strategies do not eliminate all risk.
• Commodity Trading Advisor (CTA): Asset manager who specialises in portfolios consisting of futures and options on commodities or on any other type of underlying security. Some CTA’s deal only in futures and options on stocks and bonds and do not trade in any traditional commodity market futures.
• Convertible Arbitrage: Hedge fund strategy of taking advantage when a convertible bond is mispriced compared to the theoretical value of its underlying security.
• Derivative: Financial instrument whose value depends upon the value of an underlying security. Options, forwards, and futures are examples of derivatives.
• Directional: Describing an investment strategy that relies upon the direction of an overall market movement, rather than the mis-pricing of individual securities. Global macro is an example of a directional strategy, as opposed to for example convertible arbitrage.
• Discretionary Trading: Security selection that uses the intuition of portfolio managers as well as computer models.
• Distressed Securities: The equity and debt of companies that are in or near bankruptcy or in a similar chaotic situation. Distressed securities may be purchased in an event driven hedge fund.
• Drawdown: The amount lost during a particular measurement period such as a month or year. Maximum drawdown, a common measurement, is the maximum loss during a measurement period, had an investor bought at the highest valuation during the period and sold at the lowest valuation.
• Event Driven Strategies: Hedge fund strategies that exploit anomalous pricing of securities due to corporate events such as mergers, financial distress, or debt refinancing.
• Fixed Income Arbitrage: Exploitation of anomalies in debt securities, such as unusual risk premiums, yield curve shapes, or prepayment patterns.
• Fund of Funds: Managed portfolio of other hedge funds. Also known as a “fund of hedge funds.”
• Global Macro: Hedge fund strategy where large directional bets are made, often on the direction of currency exchange rates or interest rates.
• High Water Mark: Incentive (performance) fee is based upon surpassing an absolute level of success. With a high water mark, a hedge fund that loses in its first year and then merely regains that loss in the second year will not result in the manager receiving an incentive payment for the second year gain.
• Long-Short Equity: Hedge fund strategy that is based on skill in security selection, taking both long and short positions. The resulting portfolio is not necessarily market neutral, because it may exhibit a long-bias or short-bias.
• Market Neutral: Investment strategy that does not count on a specific market movement (also known as non-directional).
• Merger Arbitrage: Investment in both companies (the acquirer and takeover candidate) involved in a merger or acquisition, anticipating either the success or failure of the event. Also known as Risk Arbitrage.
• Passive Management: Buying and holding a representative portfolio in an attempt to earn the market-wide average return without having to research security valuations. See Active Management.
• Passive Returns: Returns from holding a benchmark, such as the S&P 500 or MSCI EAFE.
• Relative Value Strategies – Broad category of market-neutral hedge fund strategies that take advantage of anomalies among related financial instruments.
• Risk Arbitrage: See Merger Arbitrage.
• Sharpe Ratio: Average return to a portfolio in excess of the risk-free return divided by the standard deviation of the portfolio return. A higher value indicates a better “reward-to-risk” tradeoff. Also called the reward-to-variability ratio.
• Special Situations: Events such as announced mergers and restructurings, spin offs, hostile takeovers, and bankruptcy situations.
• Survivorship Bias: The statistical bias in performance aggregates due to including data only from live funds, while failing to include dead (liquidated or no longer operating) funds.
• Systematic Trading: Security selection that relies upon the decisions of computer models.
• Tracking Error: How closely a portfolio return follows a benchmark return. See Active Risk.
• VaR (Value at Risk): The maximum loss to a portfolio over a given time period with a given level of confidence. For example, if a 10 day VaR at 99% confidence level is $100,000, then we conclude that 99% of the time the portfolio will not decline more than $100,000 in value within 10 days.
• Water Marks: See High Water Mark.

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