Glossary
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Absolute returns
In contrast to relative return: Investors seeking absolute returns judge the success of their investments by the degree to which they have grown from the start to end of a given period, without reference to the performance of other investments, benchmarks or the market as a whole. An absolute return is deemed to have been achieved if the value of an investment is greater at the end of the period than it was at the beginning.
Alpha
The difference between a portfolio's return and the return of its appropriate benchmark, such as an index like the S&P 500. For example, if the S&P 500 rises by 5% over a period, and a fund rises by 7% over the same period, and the fund has a sensitivity (beta) of 1 to the Index, that fund can be said to have generated 2% Alpha.
Alternative investments
Describes the category of investment funds that employ non-traditional investment techniques to generate returns. They include hedge funds, private equity, venture capital, buy-out funds and the like. Generally speaking, alternative investments show a much lower correlation to broad equity and fixed income markets than directional (long only) funds.
Arbitrage
This is a trading strategy that looks to take advantage of price differences of correlated securities, currencies or commodities. Arbitrage may also refer to trading on price differences between a derivative and its underlying security.
Benchmark
A custom or published index of a predetermined set of securities used to compare performance and risk. For example, a fund that invests in US equities could be 'benchmarked' against the S&P 500 Index, which gives a broad indication of the overall performance of US equities as a whole.
Beta
The degree to which the returns of an investment result from the returns of a specific index or benchmark. Beta can also be viewed as systematic risk, i.e. the tendency of a security's returns to respond to swings in the market. A beta of 1 indicates that the security's price will move with the market. A beta less than 1 means that the security will be less volatile than the market. A beta greater than 1 indicates that the security's price will be more volatile than the market. For example, if a stock's beta is 1.2 it's theoretically 20% more volatile than the market.
Correlation
A standardised measure of the relative movement between two variables, be they securities, indices or funds. Two assets are said to be perfectly correlated if their prices move up and down in perfect tandem and by the same amount. Two assets are said to be “perfectly negatively correlated” if they move by the same amount in opposite directions.
Derivatives
Instruments that derive their value from that of an underlying security, such as options, swaps and futures.
Downside deviation
The downside deviation is calculated like the standard deviation but is referred to losses, e.g. it measures the volatility of the negative returns only.
Draw down
Total loss in a given period.
Due diligence
An investigation or audit of a potential investment. Due diligence serves to confirm all material facts in regards to a specific investment such as investment style, risk management, the manager's background, track record, operational and legal set up etc.
Fund of funds
An investment vehicle that invests in other funds.
Hedging, to hedge
Defined as 'to secure against risk', hedging involves taking positions to offset changes in economic conditions falling outside the core investment idea, such as purchasing a long position and a short position in similar stocks to offset the effect any changes in the overall level of the equity market would have on the long position. Hedge Funds are, broadly speaking, funds that aim to produce consistent returns regardless of market performance by taking both bullish and bearish positions, i.e. positions benefiting from both a rising and falling market.
High-water mark
The highest peak in value that an investment fund/account has reached. This term is often used in the context of fund manager compensation, which is partly performance based. The high watermark ensures that the manager does not charge a performance fee after a losing period and before having recovered the losses. So if the fund performs negatively over a period, it will have to return above the high watermark before charging a performance fee. For example, if after reaching its peak in year one a fund loses $100,000 in year two, and then makes $250,000 in year three. The performance fee will only be charged on $150,000 ($250,000 - $100,000).
Hurdle rate
The minimum investment return a fund must exceed before a performance allocation/incentive fee can be taken. For example, if a fund has a hurdle rate of Libor, and the fund returns 15% for the year, and Libor is 4%, the fund will only take incentive fees on 25% minus 4%.
Leverage
Money borrowed to increase the amount of capital invested to more than 100 % of the fund net asset value. 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.
Monte Carlo simulation
A methodology for solving a problem through generation of a large number of scenarios and analysis of the collective result, which is generally a probability distribution of possible outcomes.
Qualitative analysis
A subjective analysis of a security (or a fund), with the judgement not based on financial information such as that found on a balance sheet, income statement or performance track record. Specific non-measurable factors assessed include strategy, intellectual capital, management, experience and network. They are subjective and combined with more quantitative considerations (performance returns), qualitative analysis can enhance investment decisions and portfolios.
Quantitative analysis
An analysis of a security (or a fund), with the judgement based on financial information such as that found on a balance sheet, income statement or a performance track record. Specific measurable securities or investment factors include cost of capital, value of assets; and projections of sales, costs, earnings, and profits. In the case of a fund, quantitative analysis is mostly based on statistical analysis on the performance track record on an absolute and relative basis, i.e. versus a peer group or a market. Combined with more subjective or qualitative considerations (such as management effectiveness), quantitative analysis can enhance investment decisions and portfolios.
Regression analysis
A statistical technique used to find relationships between variables for the purpose of predicting their future values
Relative return
The relative return measures the fund’s performance relative to a benchmark. For example, an investor in a US equity fund may compare the fund's performance to the S&P 500, an index of US equities. If the fund's return is 10% over a given period, and the S&P 500 return is 8%, the fund outperformed its benchmark.
Risk-free rate
Usually defined as the yield on government-issued short-term debt securities (bonds), so-called because the government's credit is said to be 'risk-free', i.e. the investor can be certain of getting the interest payments.
R-squared
A statistical measure that represents the percentage of a fund's or security's movements that are explained by movements in a benchmark index. It’s computed via ordinary least squared regression analysis. Values for r-squared range from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation.
Sharpe Ratio
The ratio of return above the minimum acceptable return (risk-free rate) divided by the standard deviation, or volatility. It provides information of the return per unit of risk, as defined by volatility.
Sortino Ratio
Similar to the "Sharpe Ratio," except it uses downside deviation for the denominator, whereas Sharpe uses standard deviation.. The Sortino Ratio was developed to differentiate between 'good' and 'bad' volatility in the Sharpe Ratio. If a fund is volatile to the upside (which is generally a good thing) its Sharpe Ratio would still be low.
Standard deviation
Commonly used to determine volatility; it is a measure of the dispersion of a group of numerical values from the mean. It is calculated by taking the differences between each number in the group and the arithmetic average, squaring them to give the variance, summing them, and taking the square root.
Traditional investments
A 'traditional investment' is a broad description of funds and other collective investment products that use more traditional investment strategies, which are, for the most part, 'long-only'. Mostly used in contrast to 'alternative investments‘.
Volatility
A measure of risk based on the standard deviation of an assets return. The greater the degree of an assets volatility, the greater the risk.
VaR
Value at risk (VaR) is a measure of the maximum potential change in the value of a portfolio of financial instruments with a given probability over a specified time horizon.