What is Net Exposure
Net exposure is the percentage difference between a hedge fund’s long and short exposures. Net exposure is a measure of the extent to which a fund’s trading book is exposed to market fluctuations. The hedge fund manager will adjust the net exposure in accordance with his or her investment outlook — bullish, bearish or neutral. 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 investment in short positions, this is called a market neutral strategy as net exposure is zero.
BREAKING DOWN Net Exposure
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, as the two measures together provide a better indication of a fund’s overall exposure.
How Leverage Impacts Net Exposure
To say a fund has a net long exposure of 20% could refer to any combination of long and short positions — 30% long and 10% short, 60% long and 40% short, or even 80% long and 60% short. Gross exposure indicates the percentage of the fund’s assets that have been deployed and whether leverage is being used. A fund with a net long exposure of 20% and 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 gross exposure of 180%, i.e., long exposure 100% less short exposure 80%, 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 does better in a down market because its short positions exceed the long ones, so it is expected that the returns on the short positions during a broad market decline 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 making a loss, the magnitude of which will again depend on its net exposure.