If you are considering a career in hedge funds, and you came across many jargons you have no idea of, you have come to the right place.
This article will list some of the most common terminologies used in the hedge fund world and explain them as simply as possible:
1. Absolute returns
Absolute return is actually the simplest, most common-sense return! There is no fancy mathematical parameters used in calculating absolute returns. Absolute returns are also used by average investors to measure the success of their investments.
Absolute return is simply the percentage gain in the amount initially invested. For example, if you invest $1 million in a very risky real estate, and 1 year later you sell your investment for $2 millions, and during that year the interest rate, cost of capital is 10%. What is your absolute return?
Simple, you take the gain, (2-1=) 1 million, divided by the initial investment, 1 million and multiply by 100.
There you go! Your absolute return in this case is 100%. You ignore the risk factor, you ignore the time value of money and everything else.
The Absolute Return strategy is one of many strategies that hedge funds employ in investing. Characteristics of this strategy is stable returns and moderate volatility. In the Absolute Return strategy, hedge funds managers use various hedging techniques to achieve stable growth, regardless of the market direction.
2. Accredited Investor
Hedge funds are not for everybody. Due to the nature of their investment strategies and financial products, only Accredited Investors are allowed to invest in hedge funds.
The Accredited Investor standard is a Regulation by the Securities and Exchange Commission (SEC) to protect average investors from losing large amount of money from risky investments. This Regulation is to ensure that investors who invest in risky financial products have sufficient fund and financial knowledge.
A person is qualified to be an Accredited Investor if he/she:
- has an individual net worth, or joint net worth with that person’s spouse exceeding $1,000,000.
- had an individual income in excess of $200,000 or $300,000 in joint income with spouse in each of the two most recent years, and likely to earn the same income level in the current year.
- is the director, executive officer or general partner of the issuer of the securities being offered or sold
3. Adjusted EBITDA
Adjusted EBITDA refers to EBITDA (Earnings before Interest, Tax, Depreciation and Amortization), adjusted to eliminate the impact of certain unusual or non-cash items that the Issuer or Borrower believes are not indicative of future performance of its business.
Adjustments to EBITDA can be:
- Unrealised gains/losses
- Non-recurring expenses such as litigation, fire losses,…
- Non-cash expenses
- Excessive owners’ compensation
4. Alpha (α)
Alpha is the difference between the investment’s excess return and the benchmark’s excess return, risk adjusted.
For example, a fund has an excess return of 15% and at the same period, the market’s excess return is 6%. This does NOT necessarily mean that Alpha is (15-6=) 9%, because this calculation has not accounted for the risk.
If we also found that the beta of that fund is 2 (twice as risky as the market), then the expected excess return of the market, given the same risk as the fund, is (6×2=) 12%.
The difference between the fund’s excess return and the expected excess return, (15-12=) 3%, is called Alpha.
An Alpha that is positive indicates that the fund has outperformed the market (or the benchmark), given the same risk.
Arbitrage is one of the main 4 categories of strategy that hedge funds employ, with the other 3 being Global Macro, Event-driven and Directional.
Arbitrage, in its purest form, is earning profit with risk-free. Riskless arbitrage occurs when the same asset is selling at different prices at the same time.
In reality, no arbitrage strategies are risk-free. Some strategies in this category include Statistical Arbitrage (Stat Arb), Convertible Arbitrage, Merger Arbitrage (also called Risk Arbitrage),…
AUM stands for Assets Under Management. It is the market value of all the assets managed by an Investment Adviser or Fund Manager.
7. Basis Point
Basis Point is 1/100 of a percentage point. For example, 100 basis points = 1%.
Basis Points is also called ‘bps’ or ‘bips’.
Basis Point is preferred because there are usually very small changes in the price or the rate of stocks and bonds. Using Basis Point to address the changes will be easier and clearer in communication.
For example, saying ’20 bps’ is easier than saying ‘0.2 percent’.
8. Beta (β)
Beta is one of the most common indicator of risk in investments. It measures the degree of fluctuation, or volatility of the security’s price in relation to the market.
The benchmark of 1.0 is in theory that of the Beta of the market. However, in practice, analysts use the Beta of stock Index like S&P 500 as the market benchmark.
A stock with a Beta less than 1.0 means that it fluctuates to a lesser degree than the market, i.e low volatility. A stock with a Beta higher than 1.0 means that it is relatively more volatile, and will fluctuate more than the market.
For example, the Amazon stock has a Beta of 1.6. When economics conditions are good and the stock market goes up by 10%, Amazon stocks will likely go up by about 16%.
Beta is used in the Capital Asset Pricing Model (CAPM), calculation of Alpha and risk-adjusted returns.
Bid price is the price at which a buyer is willing to buy a security, in contrast to Ask/Offer price, which is the price the holder of the security is willing to sell. The difference between the highest Bid and lowest Ask price is called spread.
The Bid quantity shows the number of securities demanded at a specific Bid price. The Ask/Offer quantity represents the number of securities available to be bought at a specific Ask/Offer price.
The list of buy and sell orders for a security or any financial products is called an Order Book.
Capex is short for Capital Expenditure. Expenses that can be classified as capital expenditure are the costs to buy, maintain or improve fixed assets of a company, such as Property, Plant and Equipment, Land.
Capex is often used when a company is evaluating new investment projects, or for major replacements of equipments.