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Gross and Net Exposure

What is exposure?
Exposure is the term generally used by institutional investors to describe the degree and direction the fund is invested in the market. Exposure can be calculated on gross or net assets.  However, since performance fees are usually only taken at year end, exposure numbers are generally calculated on a gross asset basis.
    Long Exposure = market value of longs / gross assets
    Short Exposure = market value of shorts / gross assets

What is gross and net exposure?
Gross exposure represents the absolute level of investment bets and can indicate the level of leverage (sometimes).  Net exposure measures the market direction of the investments portfolio/fund.  
    Gross Exposure = Long Exposure + Absolute value of Short Exposure
    Net Exposure = Long Exposure + Short Exposure

A hedge fund manager has a 100 million fund.  He invests 70 million is stocks going long, 20 million in stocks short and holds 10 million in cash.  What is the manager's exposure levels?

    Long Exposure = 70 / 100 = 70% Long
    Short Exposure = 20 / 100 = -20% Short
    Gross Exposure = 70% + Absolute of -20% = 90% Gross Exposure
    Net Exposure = 70% + - 20% = 50% Net Exposure

Importance of Exposure Levels
One exposure number doesn’t really tell a whole lot.  But using all the exposure numbers in conjunction with the fund returns can give a sense of performance drivers and sources of alpha generation.  Let’s use numbers to illustrate the point

    In 2010, the S&P 500 had a total return of 15.06%.  
    In 2010, let’s say the fund from above returned 14.00%.

Now, the fund manager and the investors are not happy that the fund returned less than the market. However, most investors look at risk adjusted returns. This manager was under invested in the market [90% gross] and had relatively low market directional risk [50% net].  So the manager was able to essentially match the return of the market by making good investment selections and did that with half the risk.

On the flip side, let’s say a fund returned 20% in 2010, but the fund had a gross exposure of 180% and a net exposure of 140%.  It would appear that excessive risk was taken (the fund would be using leverage) for not a significant increase in return.
Point to remember is that exposure calculations are taken at one point in time.

Therefore, to really understand the sources of returns for a fund more analysis needs to be done and usually done on a more frequent basis (monthly or quarterly depending on the fund strategy)