Glossary

Often referred to as hedge funds, absolute return funds operate a flexible, unconstrained investment strategy, which may include the use of gearing, derivatives and short selling to enhance returns. These attributes tend to give absolute return funds a higher risk profile than total return funds, while it is also important to remember that the majority of absolute funds are unregulated within the UK market.
There are many different investment strategies for absolute return funds, but the two most common are called market neutral and market directional. Market neutral funds aim to totally remove any general market volatility (often referred to as beta) by matching long positions (those they believe will rise in value) against short positions (those that they think will fall in price). Once this has been achieved they create returns by picking a handful of investments they are convinced will rise in value. In contrast, market directional funds actively bet on market movements in addition to trying to make returns from stock selection. They use derivatives to lessen the impact of falling markets. Absolute return funds may outperform total return funds in a sustained falling equity market as they are able to reduce their equity exposure to zero, or profit from equities falling, in the case of market directional funds. However their complex nature, lack of transparency and higher charges can put off less sophisticated investors.

Alpha is used to measure the performance of a fund in relation to its benchmark. An alpha that measures 2.0 indicates a fund has achieved a return 2% better than could have been expected from its benchmark.

An approach to risk management combining capital markets, reinsurance and investment banking techniques that allows a party to either free itself from risks not easily transferred via traditional insurance, or alternatively cover such risks in a non-traditional way – by using the capital markets for example.

A guaranteed or riskless profit from simultaneously buying and selling instruments that are perfect equivalents, the first being cheaper than the second

The distribution of investment funds within a single asset class or across a number of asset classes (such as equities, bonds and commodities) with the aim of diversifying risk or adding value to a portfolio.

A package of a cash credit instrument  and a corresponding swap that transforms the cash flows of the non-par instrument (bond or loan), into a par (floating interest rate) structure. Asset swaps typically transform fixed-rate bonds into par floaters, bearing a net coupon of Libor plus aspread, although cross-currency asset swaps, transforming cashflows from one currency to another arealso common.

The practice of matching the term structure and cashflows of an organisation’s asset and liability portfolios in order to maximise returns and minimise risk. An institutional example of this would be a bank converting a fixed rate loan (asset) by utilising a fixed-forfloating interest rate swap to match its floating rate funding (deposits).