Exposure is a fundamental concept for investors and is applicable to both individuals and institutions. The exposure of an investor can be measured in gross as well as net terms. While the net and gross exposures are very similar or exactly the same when you are implementing relatively simple investing strategies, the two figures can diverge significantly if the investor applies complex trading tactics. In the case of hedge funds, net and gross exposure tend to diverge significantly.
Hedge funds are essentially mutual funds for the rich. Like mutual funds, a hedge fund collects investments from multiple individuals and invests them to maximize returns. However, hedge funds collect money only from well-off individuals and institutions. In most instances, a hedge fund will accept an investment of no less than $1 million. Since the money in a hedge fund belongs to the rich, who are assumed to understand and be capable of handling substantial losses, these funds make risky bets in the financial markets. They are less stringently regulated and can implement strategies that most mutual funds are not allowed to use.
Selling a security short is a strategy that is off-limits to mutual funds but often used by hedge funds. A short sale occurs when an investor borrows a security from another investor to sell at prevailing prices. If the price of the security drops, the borrower can repurchase it at a lower price and profit from the decline. Say, you borrow 10 shares of a stock trading at $500, sell them for $500 apiece and pocket $5,000. If the share price drops to $450, you can buy back the same 10 shares for $4,500 and be left with $500 in profits after submitting them to the original owner.
Gross exposure of a hedge fund is the value of its long positions plus its short positions. In other words, gross exposure equals net value of all financial assets that a hedge fund is holding or has sold short. By dividing the gross exposure by the cash invested in the hedge fund and multiplying the result by 100, you can express the figure as a percentage of the cash invested in the hedge fund. If, for example, $100 million has been invested in a fund, which has sold short $50 million of stock and holds $60 million worth of shares, gross exposure is $110 million: 110 divided by 100 times 100 = 110 percent.
Net exposure equals the value of long positions -- assets purchased and still held -- minus the value of short positions. You may alternatively see net exposure expressed as "long position + short position," which is also accurate since -- technically -- short positions carry a minus sign. Adding a value with a minus sign has the same effect as subtracting it. A fund with long position of $60 million and short position of $50 million has a net exposure of $10 million. If the short position exceeds the long position, net exposure will have a minus sign and be referred to as a "net short."
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.