Net exposure is a key concept when considering long-short strategies, and refers to the percentage difference between a firms long and short exposures. Generally speaking, the lower the net exposure, the less risk the fund manager is taking. Of course managers can use leverage, which complicates this assumption. Thus net exposure should always be understood in terms of gross exposure, among other strategy considerations.

Q. So, this is a critical idea when you’re looking at hedge funds running long-short strategies, right?
A. Yes it is. A little history might be interesting here… most people say the first hedge fund was run by Benjamin Graham, the father of value investing, among his rich friends back in the 1920s: he used to buy things that he thought were relatively cheap, and sell ones he thought were relatively expensive, reckoning that he’d make money regardless of how the overall market moved. That’s the classic long-short strategy.

Q. Alright, and how does “net exposure” figure in?
A. So if you’ve got $100 on your long and $100 on your short, your net exposure to the market’s direction is zero. But most funds don’t operate like that: they have a “bias” at any particular time. Maybe they think that, overall, the market is headed up, so instead of 50-50, they might be 80% long and only 20% short. That would give the fund a “net long exposure” of 60%: 80 minus 20.

Q. So of course the fund could have net short exposure, too.
A. Yes. And if the fund uses leverage, it could have a “gross exposure” of more than 100%: it might be 120% long and 60% short, and so have a gross exposure of 180%.

Q. OK, and so what’s all this mean to a potential hedge fund investor?
A. The big takeaway is this: the lower the net exposure, the less overall risk the manager is taking. So if you see someone who’s consistently making money and only running, say, a 20% net long book, you might want to take a serious look: he’s almost certainly making money on his longs and his shorts, which is a real clue that you’ve found a true alpha generator. By the way, one thing to be a bit careful about is someone who has specific stocks that he’s long, but gets the short exposure through an index put. That may indicate a net exposure of, say, 70%; but the portfolio may not act that way in practice because of the imperfect hedge of specific stocks on one side and an index on the other.

Q. I see. Anything else to drill down on?
A. Again, what’s the gross exposure? If you’ve got someone running net 20% and gross of, say, 80% it means there’s 20% in cash… a very low risk manager. If he’s net 20% because he’s 160% long and 140% short, his gross exposure is 300%… that means lots of leverage and lots of risk!