What is “Hedge Fund Performance”?
Although the process of analyzing the performance of hedge funds could be similar to that of mutual funds, there are some specific features that investors should be mindful of. Typically they are comprised of complex investments and are not available to the wider retail audience.
Hedge funds are only accessible to sophisticated clients and institutions. This is because a hedge fund can invest in a range of instruments, not all of which are publicly traded. It employs various strategies such as short selling and derivatives trading. Therefore, measuring performance and establishing the source of returns could be tricky. In addition, hedge funds aim to provide high returns, but that often comes at the expense of also involving higher risk.
Key Learning Points
- Hedge funds typically seek to deliver absolute returns rather than comparing against a market index such as the MSCI World or S&P 500
- They use complex strategies and can invest in niche areas, therefore analyzing their risk and return profile could be trickier than doing the same for a ‘vanilla’ multi-asset portfolio
- To measure performance and risk as accurately as possible, investors have to be aware of the fund’s strategy and investment goals and can use measures such as ‘value at risk’ and ‘kurtosis’
- One of the key benefits of investing in hedge funds is diversification – they often have a low correlation to the broader market due to the nature of their underlying holdings
Absolute vs. Relative Return
Most hedge fund investors tend to analyze returns on an absolute basis, although relative comparisons are also not uncommon. Due to the variety and uniqueness of hedge funds, it is more difficult to compare or group them into different categories that have the same objective and use similar approaches.
Absolute performance measures the total return produced by a strategy over a specified period, where relative returns seek to identify how a strategy performed against a benchmark, being a market index, peer group average or a custom comparator.
How to Assess Risk?
As with mutual funds, the standard deviation is one of the key risk measures. It provides an estimate of how volatile a strategy is by measuring the dispersion of returns (dataset) relative to the mean. However, the calculation uses the concept of normal distribution of returns where the more frequent occurrence is expected to be near the mean. Most hedge funds tend to exhibit an asymmetrical return profile.
Value at Risk (VaR)
Unlike standard deviation, VaR does not consider risk in terms of volatility, but instead, it estimates the highest amount that is likely to be lost with a certain percent probability (often that is 5%). Again, the drawback here is that both the amount and probability can be underestimated due to the assumption of normal distribution (i.e. five or more standard deviations from the mean).
Kurtosis is a statistical measure that is similar to the skewness used to estimate the distribution of returns. It measures extreme values in either tail of the data and large kurtosis shows tail data exceeding the tails of the normal distribution, where low estimate shows data that is less extreme than the tails of the normal distribution.
Measuring hedge fund performance requires a more complex approach due to the more complex nature of investments and strategies. It can be quite challenging to measure performance. Along with the absolute and relative returns produced by a strategy, investors also pay considerable attention to the risk used to generate the performance.
Last but not least, risk-adjusted measures such as Sharpe, Sortino, and Treynor ratios, along with many others, can also be applied when assessing the performance of hedge funds.