Glossary

• CAPM

  Capital Asset Pricing Model. An analytical framework developed by academics that seeks to determine the required rate of return for an asset. The statistical technique of regression analysis is used to determine how the typical value of a dependent variable (i.e., a fund) changes when any one of a number of independent variables varies. Terms in CAPM include Beta, Alpha, Correlation and Standard Deviation, discussed below.

• Beta

  Often described as a standardized measure of systematic risk based upon an asset's covariance with the market portfolio, beta is also the slope of the regression line. Beta measures the risk of a particular investment relative to the market as a whole (the “market” can be any index or investment you specify). It describes the sensitivity of the investment to broad market movements. For example, in equities, the stock market (the independent variable) is assigned a beta of 1.0. An investment which has a beta of .5 will tend to participate in broad market moves, but only half as much as the market overall.

• Alpha

  The standard definition is "the return on an asset in excess of the asset's required rate of return." When evaluating fund managers, alpha is the "unexplained" return typically assigned to skill (especially by the managers themselves). But, really, it's the modeling error in the capital asset pricing model (more formally, the Y intercept of the regression line). And it can definitely be negative.

• Standard Deviation

  Standard deviation measures the dispersal or uncertainty of a variable (in this case, investment returns). It measures the degree of variation of returns around the mean (average) return. The higher the volatility of the investment returns, the higher the standard deviation will be. For this reason, standard deviation is often used as a measure of investment risk. However, standard deviation assumes a normal distribution (otherwise known as a bell curve). Typically, observed returns in absolute return strategies do not conform to such a "standard" pattern of outcomes.

• Correlation

  A number between -1 and +1 that measures the degree of co-movement between two variables. If, for example, a fund is .8 correlated to an equity index, it generally performs in a similar direction to the index. If a fund is -.8 correlated to an equity index, it tends to move counter to the index.

• Sharpe Ratio

  A return/risk measure developed by William Sharpe. Return (numerator) is defined as the incremental average return of an investment over the risk free rate. Risk (denominator) is defined as the standard deviation of the investment returns. Again, note that we're dealing in normal distributions here, which may not apply to hedge funds.

• Sortino Ratio

  This is another return/risk ratio developed by Frank Sortino. Return (numerator) is defined as the incremental compound average period return over the risk-free rate. Risk (denominator) is defined as the Downside Deviation below the risk-free rate.

• Risk-free rate

  Strictly speaking, it doesn't exist, but the closest thing to it is the rate of a government's short-term liabilities.

• Short volatility

  Writing naked options is a short volatility trade. In its most extreme, LTCM form, akin to "picking up nickels in front of a steamroller." A strategy predicated on a series of small, consistent gains, followed by larger losses. Like selling insurance, or conducting the "carry trade," or dipping into your parents' wad of singles.

• Long volatility

  Buying options is a long volatility trade. In its most extreme, Paulson subprime trade/Black Swan form, it means losing a little bit consistently before hitting it big. A strategy akin to taking out a massive life insurance policy on your spouse (before an unfortunate accident) or betting correctly on an up or down trend in the midst of choppy markets, as some systematic macro funds attempt to do.

• Implied volatility

  The volatility that option traders use to price an option, implied by the price of the option and a particular option-pricing model.

• Realized volatility

  Volatility in the rear-view mirror.

• Mean reversion

  Textbooks state, "the tendency of a time series to fall when its level is above its mean and rise when its level is below its mean; a mean-reverting time series tends to return to its long-term mean." An underlying assumption in most arbitrage strategies, especially statistical arbitrage, but also in value investing, short selling, etc.

• Security selection

  More widely referred to as "stock picking," a strategy predicated on the manager's perceived ability to differentiate profitably between similar securities due to various micro factors. The underpinning for long/short equity, some event-driven strategies and discretionary macro.

• Arbitrage

  The simultaneous purchase of an undervalued asset and sale of an over-valued but equivalent asset, in order to obtain a riskless profit on the price differential. In a normal, well-functioning market, not facing price discontinuities due to technical factors, arbitrage opportunities should not persist.

• Growth

  An investment strategy predicated on buying equities the manager perceives to be underpriced because of an underappreciation of their potential earnings growth. Growth strategies tend to fish in higher-beta pools of stocks.

• Value

  An investment strategy predicated on buying equities the manager perceives to be underpriced because of an overappreciation of headwinds to earnings. Value strategies tend to fish in lower-beta pools of stocks.

• Factor-based strategies

  A strategy predicated on exposure to a common element with which several variables are correlated, i.e., low price-to-book.

• Catalyst

  An event or piece of information that causes the marketplace to re-evaluate the prospects of a security, such as a bankruptcy court ruling.