What is net exposure?

Net exposure is the difference between a hedge fund long positions and short positions. Expressed as a percentage, this number is a measure of the extent to which the value of a fund trade book is exposed to market fluctuations.

Net exposure can be compared to a fund’s exposure gross exposure, which does not compensate for long and short positions. Net exposure is therefore often a more accurate measure of a fund’s amount at risk.

Key points to remember

  • Net exposure is the difference between a hedge fund’s short and long positions, expressed as a percentage.
  • A lower level of net exposure reduces the risk that the fund’s portfolio will be affected by market fluctuations.
  • Net exposure should ideally be considered together with a fund’s gross exposure.

Understanding net exposure

Net exposure reflects the difference between the two types of positions held in a hedge fund’s portfolio. If 60% of a fund is long and 40% is short, for example, the fund’s gross exposure is 100% (60% + 40%) and its net exposure is 20% (60% – 40%), assuming the fund uses no leverage ( see below). Gross exposure refers to the absolute level of a fund’s investments, or the sum of long and short positions.

A fund has a long fillet exposure if the percentage of the amount invested in the long positions exceeds the percentage of the amount invested in the short positions, and has a short net position if the short positions exceed the long positions. If the percentage invested in long positions is equal to the amount invested in short positions, the net exposure is nil.

A hedge fund manager will adjust net exposure based on their investment outlook—bullish, bearish or neutral. Being net long reflects a bullish strategy; being net short, bearish. Net exposure of 0%, on the other hand, is a neutral market strategy.

Gross exposure vs net exposure

Saying that a fund has a net long exposure of 20%, as in our example above, can refer to any combination of long and short positions. As an example, consider:

  • 30% long and 10% short equals 20% long
  • 60% long and 40% short equals 20% long
  • 80% long and 60% short equals 20% long

A low net exposure does not necessarily indicate a low level of risk since the fund may have a large share of leverage. For this reason, the raw exposure (long exposure + short exposure) must also be considered.

Gross exposure indicates the percentage of the fund’s assets that have been deployed and whether leverage (borrowed funds) is used. If the gross exposure exceeds 100%, it means the fund is using leverage or borrowing money to magnify Return.

Together, the two metrics provide a better indication of a fund’s overall exposure. A fund with a net long exposure of 20% and a gross exposure of 100% is fully invested. Such a fund would have a lower level of risk than a fund with a net long exposure of 20% and a gross exposure of 180% since the latter has a substantial leverage effect.

Net exposure and risk

Although a lower level of net exposure reduces the risk of wallet being affected by market fluctuations, this risk also depends on the sectors and markets that constitute the fund’s long and short positions. Ideally, a fund’s long positions should enjoy while his short positions should lose value, thus allowing both long and short positions to be closed profitably.

Even if the long and short positions rise or fall together, in the event of a broad market rise or fall, respectively, the fund may still make a profit on its overall portfolio, depending on the degree of its net exposure.

For example, a net short fund should perform better in a bear market because its short positions exceed the long positions. During a broad market decline, returns from short positions are expected to exceed losses from long positions. However, if the value of the long positions declines in value while the value of the short positions increases, the fund may experience a loss, the magnitude of which will again depend on its net exposure.

Advantages

  • Measures the expertise, the performance of the fund manager

  • Indicates the fund’s vulnerability to volatility

Example of net exposure

Looking at how a fund’s net exposure has changed over months or years and its impact on returns gives a good indication of the managers’ commitment and expertise in shorting and the fund’s likely exposure to market fluctuations.

The years 2020-2022 have been extremely volatile with significant ups and downs in stock markets driven by COVID and geopolitical events, making it a potentially challenging time for some hedge funds. However, many contained the damage by reducing their net exposure in certain sectors, according to a Morgan Stanley survey. Gross exposures also fell, reflecting a reduction in the use of leverage to boost returns, with quantitative traders cutting total equity exposure to a decade low.

As a concrete example, let’s say an investor is long on an index portfolio that tracks the S&P 500, with gross exposure of $1 million. The investor then sells short $50,000 worth of Apple stock, anticipating a loss of profits. Apple is the largest component of the S&P 500 index, so the position reduces subsequent exposure because there is an implied long position in the index portfolio.

What is net exposure versus gross exposure?

Gross exposure refers to the absolute level of a fund’s investments, including long and short positions. Net exposure represents the offsetting positions between long and short positions (eg hedges) that effectively cancel each other out.

What is the net exposure of market neutral funds?

A market neutral fund uses offsetting long and short positions to have net exposure close to zero. Instead, market neutral funds seek to profit from relative valuation errors between trading pairs.

How does hedging reduce net exposure?

A hedge is an offsetting position that reduces market risk. Say you own 1,000 shares of the SPY S&P 500 ETF starting at $425. You can buy 400-strike put options expiring in 6 months as a hedge, making the net downside exposure only a loss of $25 during that time. If the SPY falls below $400, every dollar lost in ETF stocks would be offset by gains in the put options.

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