Hedge fund net vs. gross exposures

I am having a hard time understanding the difference b/w net and gross exposures for long short equity funds.

Mathematically, net exposure is Long Percentage - Short Precentage.

Gross exposure is Long Percentage + Short Percentage.

I read Investopedia and other sources and some sources say that both net and gross exposures measure market risk. Other sources say that net exposure does not measure market risk but only gross exposure does. Which one is correct? Can someone please explain the difference between the two concepts in a simple example please?

Thank you very much

What is difficult to understand here? An individual investor or financial institution may be exposed net long or net short. If he has net position

Long - Short whereas short positions are larger, such investor (HF) is net short exposed or is net long if long positions are larger than short positions.

Gross exposure is nothing else than all long and all short positions in total, thus total long + total short exposure.

By risk management approach if an investor is net short exposed, his portfolio is adversely sensible to market upside movement.

If he is a net long exposed, a portfolio is at risk by market downfall.

Also, hypothetically an investor might have a sterile portfolio, neither net short nor net long with mutually perfectly negatively correlated positions with market risk 0. However, even such portfolio may have residual risks.

What I do not understand is that some people say that “only net exposure measures market risk” and “the lower the net exposure, the lower the market risk”. When why does gross exposure matter? We have to look at both, correct? People say that “gross exposure measures leverage and you have too look at both”. I want some sort of numerical examples to fully understand the difference b/w the two.

Could you please confirm if my understanding this correct?

  1. The higher the net exposure, the higher the market risk is, assuming that funds have the same gross exposure.

Example: Fund A has 70% long, 20% short, so its net exposure is 50% and gross exposure is 90%. Fund B has 90% long, 0% short, so its net exposure if 90% and gross exposure is 90%.

In this case, Fund B has more risk than Fund A because of its higher net exposure (given same gross exposures).

  1. The higher the gross exposure, the higher the market risk, assuming that funds have the same net exposure.

Example: Fund A has 70% long, 20% short, so its net exposure is 50% and gross exposure is 90%. Fund B has 115% long, 65% short, so its net exposure if 50% and gross exposure is 180%.

In this case, Fund B has more risk than Fund A because of its higher gross exposure (given same net exposures).

Well. At first there might be not lower market risk with lower net exposure. Eg. Fund 1 and Fund 2 have same net exposure but fund 1 is largely exposed to some specific risk like small cap stock while Fund 2 is exposed mostly to Large cap stocks.

Gross exposure matters as a measure of totally exposure and might be used as a leverage measure.

E.g. Fund has 110% total exposure (Long 60 % and short 50 %) meaning that it uses leverage.

Might not be. See the example above. Such conclusion may be only if two comparable funds have different weights allocated in exactly same assets.

These 2 Funds exactly have different risks and Fund A uses leverage. In addition Short-Long HFs usually have more than 100 % percent total exposure since they’re using leverage as explained above.

I’d say Fund B has more risk because is more leveraged.

Gross exposure matters when the offsetting exposures might not be 100% subject to the same conditions. Let’s say you are long $1 million of exposure in something with one counterparty, and short $1 million of the same thing with another counterparty, and the positions are not fully collateralized. One or both counterparties might default, so you should keep track of the net exposure.