Back to List of Terms

Absolute-return fund
A typical market-neutral hedge fund whose primary objective is to produce positive returns, rather than outperforming a particular benchmark. Such vehicles serve as a source of capital protection in falling markets. Because they are designed to be less volatile than the overall financial markets, absolute-return funds often have trouble keeping pace during strong bull markets.

Accredited investor
An institution or high-net-worth individual that meets the following criteria for investing in hedge funds under Rule 506 of Regulation D of the Securities Act of 1933:

• Net worth higher than $1 million (for individuals or married couples).
• Annual income greater than $200,000 for individuals or $300,000 for married couples in each of the last two years, as well as a reasonable expectation for such earnings in the current year.
• Employed as an officer or general partner of the fund.
• A bank, licensed broker-dealer, employee-benefit plan, trust or endowment with assets of $5 million or more that exists for a purpose other than investing in the fund.

Activist investment strategy
An approach in which a manager buys stakes in companies and seeks to become their most influential shareholder.

Administrator
A service provider that hedge funds hire to calculate fund performance, oversee shareholder relations and perform other record-keeping functions. U.S.-based fund managers that run offshore funds employ local administrators to handle back-office functions for those entities -- in order to win the tax advantages available to truly offshore vehicles.

Aggressive growth investment strategy
An approach that aims to produce the highest-possible returns by investing in relatively risky assets, employing high leverage or making speculative investments that aren't fully hedged.

Alpha
Measures the value that an investment manager produces, by comparing the manager's performance to that of a risk-free investment (usually a Treasury bill). For example, if a fund had an alpha of 1.0 during a given month, it would have produced a return during that month that was one percentage point higher than the benchmark Treasury. Alpha can also be used as a measure of residual risk, relative to the market in which a fund participates.

Alternative assets
A category of investments that includes arbitrage vehicles, commodities, distressed securities, hedge funds, managed funds, oil-and-gas partnerships, private equity, real estate, timber, venture capital or other assets whose returns aren't correlated to the stock and bond markets.

Annual rate of return
The compounded gain or loss in a fund's net asset value during a calendar year.

Arbitrage investment strategy
An approach that aims at exploiting price differentials that exist as a result of market inefficiencies. Arbitrage plays typically involve purchasing a security in one market, while selling an instrument with similar performance characteristics in another market -- earning returns that far exceed the risk incurred.

Assets under management
Includes all investments, leveraged and unleveraged, including cash, that are overseen by a fund manager.

Average annual return (annualized rate of return)
Cumulative gains and losses divided by the number of years of an investment's life, with compounding taken into account. The measure is used to compare returns on investments for periods ranging from partial to multiple years.

Average monthly return
Cumulative gains and losses divided by the number of months of the investment's life, with compounding taken into account.

Average rate of return
The mean average of a fund's returns over a given number of periods. It is calculated by dividing the sum of the rates of return over those periods by the number of periods.

Back-test
Attempts to determine the effectiveness of an investment model by applying the system to past periods and comparing those results with the actual performance of other strategies. Usually considered an inferior method of projecting future performance.

Beta
Gauges the risk of a fund by measuring the volatility of its past returns in relation to the returns of a benchmark, such as the S&P 500 index. A fund with a beta of 0.7 has experienced gains and losses that are 70% of the benchmark's changes. A beta of 1.3 means the total return is likely to move up or down 30% more than the index. A fund with a 1.0 beta is expected to move in sync with the index.

Bond-futures arbitrage investment strategy
An approach that aims to profit from pricing inefficiencies between bonds and corresponding bond futures.

Bottom-up investment strategy
An approach that seeks to identify investments that will produce strong returns, before assessing the influence that economic factors will have on those assets.

Capital-structure arbitrage investment strategy
An approach that seeks to exploit discrepancies in the valuations of various securities that a particular company offers, based on their seniority. For example, such funds might take a long position in a company's senior bank debt, while shorting its stock.

Clearing
The process of reconciling details of a securities trade that are provided by various parties to the transaction, prior to settlement. Clearing can be a highly lucrative business for securities firms, partly because the function is often linked to margin-lending activities.

Clearinghouse
A firm that works with the exchanges to handle confirmation, delivery and settlement of transactions. Also called clearing corporations or clearing firm.

Closed fund
A hedge fund or open-end mutual fund that has at least temporarily stopped accepting capital from investors, usually due to rapid asset growth. Not to be confused with a closed-end fund.

Closed-end fund
A mutual fund with a fixed number of shares outstanding that are publicly traded at a premium or discount to the fund's net asset value.

Collateralized debt obligation (CDO)
A leveraged investment vehicle that issues notes to fund the purchase of pools of bonds, loans, preferred stock, hedge-fund shares or other CDOs. Also defined as a securitization of other bonds, loans and financial instruments. Principal and interest payments on the underlying assets fund the principal and interest payments owed to holders of CDO notes. Based on the type of their underlying assets, CDOs can take a variety of forms, including collateralized bond obligations (CBOs), which are backed almost entirely by other debt securities, collateralized loan obligations (CLOs), which are backed entirely by corporate loans, and collateralized fund obligations (CFOs). Despite the similarity of the term, collateralized mortgage obligations are not part of the CDO category.

Collateralized fund obligation (CFO)
A type of collateralized debt obligation (CDO) that is backed by zero-coupon bonds to fund the purchase of shares in hedge funds, private-equity funds or multi-manager vehicles known as funds of funds. From the fund manager's standpoint, such issues serve as a source of long-term capital and behave much like funds of funds that purchase shares of their vehicles. Fund managers can earn arbitrage profits on the returns that are left after CFO holders have been made whole. CFOs are often structured as zero-coupon bonds that make lump-sum payments by redeeming the underlying fund-of-fund shares at maturity. Others have been arranged as convertible issues.

Commodity trading advisor (CTA)
A person or entity providing advise to others on investments in commodity futures, options and foreign-exchange contracts -- or invests in those instruments on behalf of others. Most CTAs must register with the Commodity Futures Trading Commission, unless they are exempt from the registration requirements.

Compounded monthly return
The average monthly increase that, when compounding is taken into account, would have produced a fund's total return over any period of time. For example, if a fund had a one-year return of 20%, its compounded monthly return would be 1.53% -- the amount it would have needed to gain in each of 12 months to achieve that full-year result.

Convergence investment strategy
An approach that exploits discrepancies in the values of securities that have historically been almost identical -- and assumes that they will ultimately become fairly priced and their values will converge.

Convertible arbitrage investment strategy
A conservative, market-neutral approach that aims to profit from pricing differences or inefficiencies between the values of convertible bonds and common stock issued by the same company. Managers of such funds generally purchase undervalued convertible bonds and short-sell the same issuers' stock. The approach typically involves a medium-term holding period and results in low volatility.

Convertible bonds
A corporate bond that can be exchanged, at the option of the holder, for a specific number of the company's common or preferred shares.

Country-specific investment strategy
An approach that involves a heavy concentration of investments, usually stocks, in one country, or a few countries within a geographical region.

Custodian
A bank, trust company or other financial institution that holds and protects a fund's assets and provides other services, including collecting money from investors, distributing redemption proceeds, maintaining margin accounts, registering investments and exercising options.

Derivative
A financial instrument whose performance is linked to a specific security, index or financial instrument. Typically, derivatives are used to transfer risk or negotiate the future sale or delivery of an investment. Derivative instruments come in four basic forms: forward contracts, futures contract, swaps and options.

Discretionary account (managed account)
A vehicle in which investors give a manager or broker discretion to buy and sell securities, futures or other assets on their behalf, either unconditionally or with restrictions.

Distressed securities investment strategy
Purchasing deeply discounted securities that were issued by troubled or bankrupt companies. Also, short-selling the stocks of those corporations. Such funds are usually able to achieve low correlations to the broader financial markets. The approach generally involves a medium- to long-term holding period.

Diversification
Generally refers to the variety of investments in a fund's portfolio. Risk-averse fund managers seek to combine investments that are unlikely to all move in the same direction at the same time.

Drawdown
The percentage loss that a fund incurs from its peak net asset value to its lowest value. The maximum drawdown over a significant period is sometimes employed as a means of measuring the risk of a vehicle. Usually expressed as a percentage decline in net asset value.

Efficient frontier
The combination of securities that maximizes the expected return for any level of expected risk, or that minimizes expected risk for any level of expected return.

Eligible investor
A person deemed by a registered investment advisor to have a net worth of $1 million or at least $500,000 under management with the advisor. Under Section 205(a) and Rule 205-3 of the Investment Adviser Act, investment advisors are prohibited from receiving hedge-fund-like compensation based on a share of the gains, unless certain conditions are met. One of those conditions is that the advisor's clients are "eligible investors." Another condition is that the performance fee is based on gains and losses for a period of not less than one year.

Emerging-markets investment strategy
Investing in stocks or bonds issued by companies and government entities in developing countries, usually in Latin America, Eastern Europe, Africa and Asia. Such funds typically employ a short- to medium-term holding period and experience high volatility.

Event-driven investment strategy
An approach that seeks to anticipate certain events, such as mergers or corporate restructurings. Such funds, which include risk-arbitrage vehicles and entities that buy distressed securities, typically employ medium-term holding periods and experience moderate volatility.

Event risk
The likelihood that an investment's value will change as the result of unexpected events, such as corporate restructurings, a takeovers, regulatory shifts or disasters.

Exposure
The extent to which a hedge fund is vulnerable to changes in a given financial market. Exposure can be measured on a net or gross basis. Net exposure takes into account the benefits of offsetting long and short positions and is calculated by subtracting the percentage of the fund's equity capital invested in short sales from the percentage of its equity capital used for long positions. For example, if a fund is 125% long and 50% short, its net exposure would be 75%. Gross exposure is calculated by adding the percentage of the fund's equity invested in short sales to the percentage of its equity used for long positions. In both cases, the exposures often exceed 100% because they don't account for the use of leverage.

Fair value
The price at which a single unit of a security would trade between parties that don't have interests in the issue. Fair value does not take into account various premiums or discounts that would be assessed for large or illiquid positions.

Fixed income investment strategy
An approach in which the manager invests primarily in bonds, annuities or preferred stock. The investments can be long positions, short sales or both. Such funds are often highly leveraged.

Fixed-income arbitrage investment strategy
An approach that aims to profit from pricing differentials or inefficiencies by purchasing a bond, annuity or preferred stock and simultaneously selling short a related security. Such funds are often highly leveraged.

Forward contract
A private, over-the-counter derivative instrument that requires one party to sell and another party to buy a specific security or commodity at a pre-set price on an agreed-upon date in the future. Similar to a futures contract, which is traded on an exchange.

Fund of funds (multi-manager vehicle)
An investment vehicle whose holdings consist of shares in hedge funds and private-equity funds. Some of these multi-manager vehicles limit their holdings to specific managers or investment strategies, while others are more diversified. Investors in funds of funds are willing to pay two sets of fees, one to the fund-of-funds manager and another set of (usually higher) fees to the managers of the underlying funds.

Fundamental analysis investment strategy
An approach that relies on valuing stocks by examining companies' financials and operations, including sales, earnings, growth potential, asset size and quality, indebtedness, management, products and competition.

Futures contract
An exchange-traded agreement to buy or sell a particular type and quantity of commodity or security for delivery at an agreed-upon place and date in the future. Futures, which are popular hedging tools, can be derivatives of agricultural products, metals, petroleum products, government securities and individual issues of common stock. They are similar to forward contracts, which are traded privately.

General partner
The individual or firm that organizes and manages a limited partnership, such as a hedge fund. The general partner assumes unlimited legal responsibility for the liabilities of a partnership.

Global-macro investment strategy
An approach in which a fund manager seeks to anticipate broad trends in the worldwide economy. Based on those forecasts, the manager chooses investments from a wide variety of markets -- i.e. stocks, bonds, currencies, commodities. The approach typically involves a medium-term holding period and produces high volatility. Many of the largest hedge funds follow global-macro strategies. They are sometimes called "macro" or "global directional-investment" funds.

Grandfathered fund
A Section 3(c)(1) hedge fund that can convert to a Section 3(c)(7) fund without removing existing shareholders who aren't "qualified investors." As many as 100 investors who don't meet the qualified-investor criteria may continue to hold shares in a grandfathered fund, provided their investments were made on or before Sept. 1, 1996.

Haircut
The amount by which a lender discounts the actual market value of collateral pledged by a borrower.

Hedge fund
A private investment vehicle whose manager receives a significant portion of its compensation from incentive fees tied to the fund's performance -- typically 20% of annual gains over a certain hurdle rate, along with a management fee equal to 1% of assets. The funds, often organized as limited partnerships, typically invest on behalf of high-net-worth individuals and institutions. Their primary objective is often to preserve investors' capital by taking positions whose returns are not closely correlated to those of the broader financial markets. Such vehicles may employ leverage, short sales, a variety of derivatives and other hedging techniques to reduce risk and increase returns. The classic hedge-fund concept, a long/short investment strategy sometimes referred to as the Jones Model, was developed by Alfred Winslow Jones in 1949.

Hedged equities investment strategy
An approach that seeks to reduce investors' exposure to volatility in the stock market by offsetting a portfolio of common stocks with short positions and index options.

High-water mark
A provision serving to ensure that a fund manager only collects incentive fees on the highest net asset value previously attained at the end of any prior fiscal year -- or gains representing actual profits for each investor. For example, if the value of an investor's contribution falls to, say, $750,000 from $1 million during the first year, and then rises to $1.25 million during the second year, the manager would only collect incentive fees from that investor on the $250,000 that represented actual profits in year-two.

Hurdle rate
The minimum return necessary for a fund manager to start collecting incentive fees. The hurdle is usually tied to a benchmark rate such as Libor or the one-year Treasury bill rate plus a spread. If, for example, the manager sets a hurdle rate equal to 5%, and the fund returns 15%, incentive fees would only apply to the 10% above the hurdle rate.

Incentive fee (performance fee)
The charge -- typically 20% -- that a fund manager assesses on gains earned during a given 12-month period. For example, if a fund posts a return that is 40% above its hurdle rate, the incentive fee would be 8% (20% of 40%) -- provided that the high-water mark does not come into play.

Inception date
The day on which a fund starts trading.

International investment strategy
Purchasing securities issued by non-U.S. companies that are located in developed countries, as opposed to emerging markets. The approach offers diversification to U.S. investors, since the performance of foreign markets aren't correlated to returns on investments at home. Such funds typically employ medium-term holding periods and experience high volatility.

Joint back office
A clearing operation that a hedge fund jointly owns with a prime broker for the purpose of exceeding the Federal Reserve's Regulation T limits on margin borrowing. By assuming an ownership stake in such a clearing operation, a fund can effectively render all transactions with its prime broker as internal transfers -- giving the prime broker the ability to reduce margin loan requirements substantially, under Section 220.7(c) of Regulation T. By setting up a joint back office, a hedge fund can borrow an amount equal to many times its equity capital. Most other U.S. investors can leverage only half of their investments, under Reg T.

Jones model
An investment approach developed by former journalist Alfred Winslow Jones, who is said to have created the first hedge fund in 1949. Unlike traditional long-only mutual funds, the Jones model involved a limited partnership that employed a long/short investment strategy -- thus hedging the portfolio against market fluctuations. Jones, who was committed to capital preservation, targeted absolute returns rather than a return that was correlated to the broad stock market. He charged investors a performance equal to 20% of annual gains. He also invested his own money in the fund.

Lamp letter
A May 6, 1997, "no-action letter" from the SEC to Lamp Technologies of Dallas indicating that an online hedge-fund database would not violate restrictions against marketing hedge funds. The landmark letter cleared the way for others to launch hedge-fund performance databases on the Internet, and expressed the SEC's opinion that such databases did not represent the type of general hedge-fund advertising that was prohibited under rule 502(c) of Regulation D under the Securities Act of 1933.

Leverage
The borrowed money that an investor employs to increase buying power and increase its exposure to an investment. Users of leverage seek to increase their overall invested amounts in hopes that the returns on their positions will exceed their borrowing costs. The extent of a fund's leverage is stated either as a debt-to-equity ratio or as a percentage of the fund's total assets that are funded by debt. Example: If a fund has $1 million of equity capital and it borrows another $2 million to bring its total assets to $3 million, its leverage can be stated as "two times equity" or as 67% ($2 million divided by $3 million). Ratios of between two and five to one are common. Leverage can also come in the form of short sales, which involve borrowed securities.

Limited partnership
Many hedge funds are structured as limited partnerships, which are business organizations managed by one or more general partners who are liable for the fund's debts and obligations. The investors in such a structure are limited partners who do not participate in day-to-day operations and are liable only to the extent of their investments.

Liquidity
The ease with which an investment product can be sold in large volumes, without impacting its price. Hedge funds typically offer quarterly or annual liquidity, meaning that they allow investors to redeem their shares that often.

Liquidity risk
The potential that an investor will be unable to convert its holdings into cash quickly and in large quantities without having to accept a substantial discount. The term also refers to the potential that a securities buyer will not have enough money to pay for the purchase.

Lock-up
The period of time -- often one year -- during which hedge-fund investors are initially prohibited from redeeming their shares.

Long-biased investment strategy
An approach taken by fund managers who tend to hold considerably more long positions than short positions.

Long-only investment strategy
An approach that involves no short positions. While most mutual funds hold only long positions, the strategy is uncommon for hedge funds.

Long/short investment strategy
An approach in which fund managers buy stocks whose prices they expect will increase and takes short positions in securities (usually in the same sector) whose prices they believes will decline. The strategy, also known as the Jones Model, is designed to generate profits during bullish periods in the overall stock market, while serving as a source of capital protection in a falling stock market.

Managed futures
A vehicle in which an investor gives a commodity trading advisor -- usually a manager or broker -- discretion or authority to buy and sell futures contracts, either unconditionally or with restrictions. A type of discretionary account.

Management fee
The charge that a fund manager assesses to cover operating expenses. Investors are typically charged separately for costs incurred for outsourced services. The fee generally ranges from an annual 0.5% to 2% of an investor's entire holdings in the fund, and it is usually collected on a quarterly basis.

Margin loan
A line of credit from a broker that provides an investor with capital for the purpose of purchasing securities. The loan usually finances up to 50% of the securities purchase and is secured by stock owned by the client. Hedge funds can usually leverage themselves far more than that through other means, such as joint back offices. Like any form of leverage, a margin loan allows investors to boost their buying power, while at the same time increasing their risk. The value of the securities an investor holds in a margin account must be maintained above a minimum level in order for the loan to remain in good standing. If the value of the collateral falls below the threshold, the investor will get a margin call, also known as a Regulation T (Reg T) call.

Margin call
Occurs when a broker demands that the holder of a margin loan put up extra cash or securities as collateral for that loan, usually because the value of the securities purchased with the loan has declined. When such a Regulation T call is made, an investor has the option to put up cash to reduce the loan amount, add more securities to the margin account to raise the portfolio value or sell securities in the account to reduce the loan balance.

Market-neutral investment strategy
An approach that aims to preserve capital through any of several methods and under any market conditions. The most common followers of the market-neutral strategy are funds pursuing a long/short investment strategy. These seek to exploit market discrepancies by purchasing undervalued securities and taking an equal, short position in a different and overvalued security. Market-neutral funds typically employ long-term holding periods and experience moderate volatility.

Market-neutral option arbitrage investment strategy
An approach that seeks to exploit pricing differentials between options contracts or warrants and the stocks to which they are tied. Those following the strategy typically purchase options or warrants, while taking short positions in the underlying stocks.

Market timer
A hedge-fund manager that selects asset allocations in anticipation of movements in the broad market.

Master-feeder fund
A common hedge-fund structure through which a manager sets up two separate vehicles -- one based in the U.S. and an offshore fund that is domiciled outside the U.S. -- which serve as the only investors for a third non-U.S. fund. The two smaller entities are known as feeder funds, while the large offshore vehicle acts as the master fund. The purpose of such an arrangement is to create a single investment vehicle for both U.S. and non-U.S. investors.

Merger arbitrage investment strategy
Trading the stocks of companies that have announced acquisitions or are the targets of acquisitions. Seeks to exploit deviations of market prices from proposed exchange formulas.

Minimum investment
The smallest amount that an investor is permitted contribute to a hedge fund as an initial investment. Minimum investment requirements can range from $50,000 to $5 million, but most funds insist on $500,000 to $1 million.

Mortgage-backed securities arbitrage investment strategy
An approach that seeks to exploit pricing differentials between various issues of mortgage-related bonds.

Multi strategy
An investment style that combines several different approaches. The term often applies to funds of funds that allocate capital to a diverse group of hedge-fund managers.

Net asset value (NAV)
The market value of a fund's total assets, minus its liabilities and intangible assets, divided by the number of its shares outstanding. The measure is used to determine prices available to investors for redemptions and subscriptions. Hedge funds typically calculate their NAVs at the end of every business day, but report them to investors on a monthly basis. Mutual funds report their NAVs daily.

Net-fee requirement
An SEC rule stating that hedge-fund managers and other types of investment advisors must deduct "advisory fees" they charge from any performance figures they present to prospective investors.

Netting
The process of adjusting a gross amount, usually by subtracting. The term usually applies to the deduction of fees and taxes from an investment's return.

Offshore fund
An investment vehicle that is domiciled outside the U.S. and has no limit on the number of non-U.S. investors it can take on. Although the fund's securities transactions occur on U.S. exchanges and are executed by a U.S. manager, or general partner, its administration and audits are conducted offshore -- usually in a tax haven like the Cayman Islands. Because it is administered outside the U.S., non-U.S. investors and such U.S. investors as pension funds and other tax-exempt entities aren't subject to U.S. taxes.

Operational risk
Measures the probability that investment losses will result from factors other than credit risk, market risk or liquidity risk, such as employee fraud or misconduct, errors in cashflow models, incorrect or incomplete documentation of trades or man-made disasters.

Opportunistic investment strategy
An approach that seeks to produce the greatest possible returns by making aggressive investments in the most-efficient products at a given time. Such funds typically hold their investments for five to 30 days, based on the momentum of the investments' values. They usually experience low volatility.

Opportunistic value investment strategy
An approach that seeks to produce the greatest possible returns by assuming long-term positions in the most-efficient products at a given time. Such funds, which often pursue long/short investment strategies, may hold a variety of investments, including stocks, bonds, options and warrants, as well as distressed securities.

Option
A contract that gives parties the right to buy, or sell, a specific asset or security at a specified strike price by a pre-set date. It falls under the derivatives category and comes in the form of calls (options to buy) and puts (options to sell). The cost of an option is generally a fraction of the cost of its underlying security.

Options arbitrage investment strategy
An approach that seeks to exploit pricing differentials between similar option contracts or between the price of an option contract and its associated securities.

Options investment strategy
Any of a number of approaches in which the manager invests in option contracts.

Pairs trading investment strategy
An approach that seeks to identify similar companies whose securities are trading at a wide differential. The manager of such a fund would assume a short position in the overvalued security, while taking a long position in the undervalued one.

Payment netting (netting by novation)
A form of netting in which multiple payments between two parties are combined into a single "master agreement" that allows for one payment on a specified date, and in a specified currency. The practice is common in the foreign-exchange market, where parties often have large numbers of offsetting payments due on the same day, and in the same currency.

Performance trigger
The point at which a hedge fund's losses cause specific contractual provisions designed to insulate investors from further losses.

PIPEs
Acronym for private investments in public entities. Investments typically made by funds following Regulation D investment strategy.

Pooled investment vehicle
Any limited partnership, trust or company that operates as an investment fund and is exempt from SEC registration under the Investment Company Act of 1940.

Portfolio manager
A company or individual that runs capital on behalf of an investment fund, such as a hedge fund. The portfolio manager is often the general partner of the fund's limited partnership. It may be an employee of the fund-management firm, or an external entity with which the hedge fund makes a passive investment.

Portfolio turnover rate
The rate of trading activity in a hedge fund or mutual fund, expressed as a percentage of the portfolio's size, that is bought or sold each year. Calculated by dividing the lesser of purchases or sales by average assets during that year.

Prime broker
A large bank or securities firm that provides various administrative, back-office and financing services to hedge funds and other professional investors. Prime brokers can provide a wide variety of services, including trade reconciliation (clearing and settlement), custody services, risk management, margin financing, securities lending for the purpose of carrying out short sales, recordkeeping, and investor reporting. A prime brokerage relationship doesn't preclude hedge funds from carrying out trades with other brokers, or even employing others as prime brokers. To compete for business, some prime brokers act as incubators for funds, providing office space and services to help new fund managers get off the ground.

Principal-protected note
Structured securities that promise hedge-fund returns without risking an investor's principal. Investors receive hedge-fund returns, minus a 1% to 2% fee required by a financial institution to guarantee buyers' principal amounts. Principal-protected notes give investors a safe haven from stock- or bond-market volatility, while providing a way for risk-averse investors -- such as insurance companies and endowments -- to invest in hedge funds that would otherwise be off-limits to them. The issues are often sponsored by a bank guarantor, with proceeds going to a group of hedge funds. To protect its own position, the guarantor bank reserves the right to redeem shares from any or all hedge funds in the pool when the combined net-asset value of the fund shares falls below certain levels.

Private-equity fund
Entities that buy illiquid stakes in privately held companies, sometimes by participating in leveraged buyouts. Like hedge funds, the vehicles are structured as private investment partnerships in which only qualified investors may participate. Such funds typically charge a management fee of 1.5% to 2.5%, as well as an incentive fee of 25% to 30%. Most private-equity funds employ lock-up periods of five to ten years, longer than those of hedge funds.

Private placement
Issues that are exempt from public-registration provisions in section 4-2 of the Securities Act of 1933. Hedge fund shares are generally offered as private placements, which are typically offered to only a few investors, rather than the general public. They must meet the following criteria:

• The issuer must believe that the buyer is capable of evaluating the risks of the transaction.
• Buyers have access to the same information that would appear in the prospectus of a publicly offered issue.
• The issuer does not sell the securities to more than 35 parties in any 12-month period.
• The buyer does not intend to sell the securities immediately for a trading profit.

Qualified investor
Any individual whose investment portfolio is valued at $5 million or more, or any company that owns or manages at least $25 million of investments. Hedge funds may have up to 500 qualified investors, provided that all of the shareholders meet those criteria, under Section 3(c)(7) of the Investment Company Act of 1940. Qualified investors are typically wealthier than accredited investors or eligible investors.

R-squared
A measure of the degree to which a hedge fund's returns are correlated to the broader financial market. A figure of 1 would be a perfect correlation, while 0 would be no correlation and minus-1 would be a perfect inverse correlation. Any figure below 0.3 is considered non-correlated. The result is used to determine whether a hedge fund follows a market-neutral investment strategy. Sometimes referred to as "R."

Rate of return
The annual appreciation in the value of a fund or any other type of investment, stated as a percentage of the total amount invested. Sometimes referred to a simply the "return."

Redemption fee
A charge, intended to discourage withdrawals, that a hedge-fund manager levies against investors when they cash in their shares in the fund before a specified date.

Redemption notice period
The amount of advance notice that an investor must give a hedge-fund manager before cashing in shares of the fund. Notification is usually required in writing.

Redemption
Liquidation of shares or interests in an investment fund.

Regional investment strategy
An approach in which the fund manager invests in instruments that are issued by companies or governments in a specific geographical region.

Regulation D
A provision in the Securities Act of 1933 that allows privately placed transactions to take place without SEC registration and prohibits hedge funds from advertising themselves to the general public. It also outlines which parties qualify as company insiders.

Regulation D investment strategy
An approach in which the fund manager provides financing to publicly traded companies, usually in exchange for a privately placed convertible note issued at a discount. Also known as PIPEs (private investments in public entities).

Regulation T
A Federal Reserve Board rule that dictates requirements for margin loans and differentiates "listed" and "unlisted" securities. Listed, or registered, securities are subject to more-stringent borrowing limits.

Relative-value investment strategy
A market-neutral investment strategy that seeks to identify investments whose values are attractive, compared to similar securities, when risk, liquidity and return are taken into account.

Reporting agent
A third-party individual or company that verifies a fund's performance figures.

Risk arbitrage investment strategy
Purchasing stocks of companies that are likely takeover targets, while assuming short positions in the would-be acquiring companies. Risk arb players can employ an event-driven investment strategy or merger arbitrage investment strategy, seeking situations such as hostile takeovers, mergers and leveraged buyouts. Such funds typically experience moderate amounts of volatility.

Risk-free rate
The theoretical return on a risk-free investment, usually a U.S. security.

Rule 506
Provision in the Securities Act of 1933 that defines an accredited investor.

Section 3(c)(1)
A provision in the Investment Company Act of 1940 that allows certain hedge funds to be established without registering as investment advisors, provided their shares are owned by 99 or fewer shareholders that meet the qualifications of an accredited investor. Qualifying funds may also have only non-accredited investors, as long as there are no more than 35 shareholders. In many cases, hedge-fund managers establish their vehicles as Section 3(c)(1) funds because they don't anticipate taking on more than 99 investors. In cases where they do want to add investors, they may convert to Section 3(c)(7) funds.

Section 3(c)(7)
A provision in the Investment Company Act of 1940 that allows certain hedge funds to bypass investor limitations placed on Section 3(c)(1) funds, giving them the latitude to take on as many as 500 shareholders that meet the standards of a qualified investor. A Section 3(c)(7) fund with more than 500 investors may be required to register with the SEC.

Sector investment strategy
Limiting investments to securities issued by companies that operate in a particular industry sector, such as finance, energy, healthcare or high-tech. Some managers pursue multi-sector strategies that involve more than one sector.

Settlement
Synonymous with a transaction's closing, when, after clearing has taken place, securities are delivered and payment is received.

Sharpe ratio
A measure of how well a fund is rewarded for the risk it incurs. The higher the ratio, the better the return per unit of risk taken. It is calculated by subtracting the risk-free rate from the fund's annualized average return, and dividing the result by the fund's annualized standard deviation. A Sharpe ratio of 1:1 indicates that the rate of return is proportional to the risk assumed in seeking that reward. Developed by Prof. William R. Sharpe of Stanford University.

Short-biased investment strategy
An approach that relies on short sales. Such funds tend to hold larger short positions than long positions.

Short-only investment strategy
An approach that seeks to profit exclusively by short sales -- taking short positions in securities whose values the fund manager believes will fall. Such funds typically employ medium-term holding periods and experience high amounts of volatility.

Short sales
The process of borrowing securities or futures contracts from a broker and "selling them short" with the expectation that the same asset can later be purchased at a lower price. The sale is covered by buying back the securities (hopefully at a lower price) and returning them to the lending broker.

Short-term trading strategy
An approach in which the fund manager focuses on opportunistic trades, holding investments for only brief periods. Such funds often engage in "day trading."

Small cap/micro cap investment strategy
Purchasing stocks issued by small companies. Small-cap companies generally have $250 million to $1 billion of market capitalization, while micro-cap companies have less than $250 million of market capitalization.

Soft dollars
Credits that can be used to pay for research and other services that brokerage firms provide to hedge funds and other investor clients in return for their business. Those credits are accumulated through soft-dollar brokers, which channel trades to multiple securities brokers.

Sophisticated investor
Any investor who is capable of assessing the risks involved with a hedge fund -- either alone, or with the help of an investment advisor -- as described in Rule 506 of Regulation D of the Securities Act of 1933.

Sortino ratio
Also called the "upside potential ratio." Similar to the Sharpe ratio, it was developed by the Pension Research Institute to determine the amount of "good" volatility that a fund's investment portfolio possesses -- that is, it seeks to define the amount by which the investment pool's value may increase, based on expected pricing fluctuations.

Special situations investment strategy
An event-driven investment strategy in which the manager seeks to take advantage of unique corporate situations that provide the potential for investment gains.

Specialized hedged financing
An approach in which the hedge-fund manager purchases privately placed junk-rated securities and then hedges against the risk that those securities will default. Because the investments are typically in danger of defaulting, they tend sell at deep discounts and carry unusually high yields.

Spread
The difference in price or yield between two securities. Most often used to describe the difference between the yield on a Treasury security and the yield on another type of bond. It also refers to the return from a given investment product, such as a hedge fund, versus the return of a benchmark such as the S&P 500 index.

Standard deviation
For an investment portfolio, it measures the variation of returns around the portfolios mean-average return. In other words, it expresses an investment's historical volatility. The further the variation from the average return, the higher the standard deviation.

Statistical arbitrage investment strategy
A market-neutral investment strategy that seeks to simultaneously profit and limit risk by exploiting pricing inefficiencies identified by mathematical models. The strategy often involves short-term bets that prices will trend toward their historical norms.

Stock-futures arbitrage investment strategy
An approach that seeks to take advantage of differences between a stock's current price and its expected future price by buying a group of stocks and shorting futures contracts in the corresponding index -- or by purchasing the futures contracts and short selling the stock.

Swap contract
An agreement by two or more parties to exchange currencies, commodities, interest payments, investment returns or cash flows, either presently or at a future date. Swaps are a form of derivatives. Interest-rate swaps, which are usually used to convert a fixed-rate investment into a floating-rate instrument, and vice versa, are the most common example of a swap. Credit-default swaps and rate-of-return swaps are used to ensure specific returns on investments, with the swap counterparty assuming the risk.

Survivorship bias
An over-estimation of historic returns for the hedge-fund industry that results from the tendency of poor-performing hedge funds to drop out of an index while strong performers continue to be tracked. The result is a sample of current funds that includes those that have been successful in the past, while many funds that underperformed are not included.

Ten commandments
Provisions once included in Section 864 of the U.S. Tax Code that required the principal office of an offshore fund or other type of foreign partnership to be located outside the U.S. They were repealed as part of the Tax Payer Relief Act of 1997 because Congress wanted to bring administrative jobs back to the U.S. from offshore locations and remove cost burdens from U.S. investment managers. The IRS used the "commandments" to determine whether funds that operated outside the U.S. were subject to U.S. income taxes. Thanks to the repeal, offshore funds are now able to locate their principal offices in the U.S. without incurring federal income-tax liability.

Top-down investment strategy
An approach that seeks to assess the influence of various macro-and micro-economic factors before identifying individual investments.

Traditional investments
Products whose performances closely track the broader stock and bond markets.

Value investment strategy
An approach that involves purchases of stocks that the manager deems to be priced below their intrinsic values, or are out of favor with the market but are still fundamentally solid. Such funds typically employ long-term holding periods and experience low volatility.

Value at risk (VaR)
A measure of the potential change in value that a fund's portfolio may experience during that vehicle's holding period. It is usually expressed as a percentage, which is referred to as a confidence level.

Value-added monthly index (VAMI)
The value that $1,000 allocated to an investment fund on its inception date would currently have, assuming that all profits and distributions were reinvested.

Venture capital
Money given to corporate start-ups and other new high-risk enterprises by investors who seek above-average returns and are willing to take illiquid positions.

Volatility
The likelihood that an instrument's value will change over a given period of time, usually measured as beta.

Volatility arbitrage investment strategy
An approach by which a manager seeks to take advantage of fluctuations and inefficiencies in financial markets, usually the stock market. A common form of volatility arbitrage is an options arbitrage investment strategy, which can be carried out as a market-neutral investment strategy or with a long bias toward volatility. The returns are generally expected to have low correlation to those of the stock or bond markets.

Warrant
A contract that gives an investor the right to purchase a security at a specific price (usually above the current price) on a future date. It is usually issued with a bond or preferred stock to provide additional incentive to the buyer. Warrants are similar to options contracts, but unlike options, they can stay in effect for a period ranging from a few years to eternity.