Hedge funds use a lot of esoteric language. We’ve given brief definitions here to some of the key terms we’ve used that will help you to understand what a hedge fund is and how they operate.

Alpha

Alpha is a measure of manager skill, it is the return a hedge fund makes over the return of the market as a whole.

Arbitrage

Arbitrage is a way of exploiting small price differences in the same or similar securities across multiple markets, by purchasing it in the cheaper market and immediately selling it in the more expensive market. It is a lower-risk hedge fund investment strategy.

Beta

Beta measures the systematic risk of a hedge fund portfolio to the market as a whole, i.e. how much wider market moves have historically impacted the portfolio.

Derivatives

A derivative is a financial instrument (e.g. an option, a future, a swap, a warrant, a forward contract) structured as a bilateral contract, or an exchange traded, listed derivative, where the value is based upon an agreed upon asset (e.g. an interest rate, a stock, a physical commodity etc.).

Directional funds

Directional hedge funds are those that don’t hedge away their risk, they keep exposure to a market and try to get higher returns for the risk they engage in.

Leverage

Where hedge funds borrow money, typically to amplify returns. This will, however, also increase the scale of potential losses if they happen. There are many ways to employ leverage, e.g. by using derivatives like options and futures, or using margin accounts, physically borrowing from other counterparties or via repurchase agreements (repos).

Market neutral

A market neutral hedge fund mitigates market risk by having limited beta to the market. It does this by pairing long and short investments. By being market neutral it seeks to generate positive returns regardless of whether the overall market is going up or down.

Net and gross exposure

Gross exposure is the sum of a hedge fund’s long and short positions, usually expressed as a percentage i.e. if a fund is 70% long and 30% short = 100% gross exposure

Net exposure is the difference between a hedge fund’s long and short positions, usually expressed as a percentage i.e. if a fund is 70% long and 30% short = 40% net exposure.

Platform

Platform funds are multi-manager funds where there are many teams of traders that operate autonomously. They have stringent risk parameters, and are limited in the magnitude of losses (drawdowns) they can experience before remedial action from the fund’s management. Leverage is employed at the overall platform level, rather than at the individual trader level.

Portfolio manager (“PM”)

Portfolio managers are responsible for designing the investment strategy of a hedge fund and for the implementation of that strategy. They manage the risk of the portfolio and make final trading decisions.

Relative value

A relative value hedge fund strategy seeks to exploit differences in the prices of related securities.

Single vs multi-manager funds

A single manager hedge fund is run by a single portfolio manager, whereas a multi-manager fund has multiple PMs. As a result, multi-manager funds tend to invest in more varied sectors and diversified instruments.