What Is Net Exposure?
Net exposure is the difference between a hedge fund’s long positions and its short positions. Expressed as a percentage, this number is a measure of the extent to which a fund’s trading book is exposed to market fluctuations.
Net exposure can be contrasted with a fund’s gross exposure.
- Net exposure is the difference between a hedge fund’s short positions and long positions, expressed as a percentage.
- A lower level of net exposure decreases the risk of the fund’s portfolio being affected by market fluctuations.
- Net exposure should ideally be considered along 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 (more on that below). The gross exposure refers to the absolute level of a fund’s investments, or the sum of long positions and short positions.
A fund has a net long exposure if the percentage amount invested in long positions exceeds the percentage amount invested in short positions, and has a net short position if short positions exceed long positions. If the percentage invested in long positions equals the amount invested in short positions, the net exposure is zero.
A hedge fund manager will adjust the net exposure following their investment outlook—bullish, bearish, or neutral. Being net long reflects a bullish strategy; being net short, a bearish one. Net exposure of 0%, meanwhile, is a market neutral strategy.
Gross Exposure vs. Net Exposure
To say a fund has a net long exposure of 20%, as in our example above, could 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 significant deal of leverage. For this reason, gross exposure (long exposure + short exposure) should also be considered.
Gross exposure indicates the percentage of the fund’s assets that have been deployed and whether leverage (borrowed funds) is being used. If gross exposure exceeds 100%, it means the fund is using leverage—or borrowing money to amplify returns.
The two measures together 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 degree of leverage.
Net Exposure and Risk
While a lower level of net exposure does decrease the risk of the fund’s portfolio 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 appreciate while its short positions should decline in value, thus enabling both the long and the short positions to be closed at a profit.
Even if both the long and short positions move up or down together—in the case of a broad market advance or decline, 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 do better in a down market because its short positions exceed the long ones. During a broad market decline, it is expected that the returns on the short positions will exceed the losses on the long positions. However, if the long positions decline in value while the short positions increase in value, the fund may find itself taking a loss, the magnitude of which will again depend on its net exposure.
Measures fund manager’s expertise, performance
Indicates fund’s vulnerability to volatility
Example of Net Exposure
Looking at how a fund’s net exposure varies over the months or years and its impact on returns gives a good indication of the managers’ commitment to and expertise on the short side and the fund’s likely exposure to swings in the market.
The year 2018, with its volatile stock market moves, was a tough one for hedge funds. However, many contained the damage by reducing their net exposure from 80% in January to around 60% by November, according to a Goldman Sachs survey.
Gross exposures declined as well, reflecting a reduction in the use of leverage to boost returns. One fund, Suvretta Capital Management, kept its net exposure at 50%, but cut gross exposure from 160% to 60% in October 2018, indicating it didn’t want to have much debt on its books—lest a market drop cause that debt to mushroom.
View more information: https://www.investopedia.com/terms/n/net-exposure.asp