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Hedge funds offer unique return opportunities not generally available through traditional long only stock and bond investments. Hedge funds are considered to be ‘absolute return’ vehicles for which returns are expected to be positive even when equity markets perform poorly.
When assessing the performance of a manager, hedge fund indices such as the Greenwich Global Hedge Fund Indices can be used as benchmarks for hedge fund performance. An appropriate benchmark will reflect the particular strategy of an investment manager and can serve as a proxy for the manager in studies of risk and return performance and asset allocation.
There is a number of performance measures commonly used when reporting hedge fund performance. It is important to note that no one measure can adequately describe a fund’s performance. The investor must have the skill to interpret a number of performance measures to gain more reliable insight into the fund’s risk and return characteristics.
Alpha measures excess return, relative to a representative benchmark. It is common to compare a manager’s performance to that of a risk-fee investment (usually a Treasury bill) or to a benchmark that represents the market in which the fund participates such as the Greenwich Global Hedge Fund Index.
Alpha = RFund - RBenchmark
For example, if a fund had an alpha of 2.0, it would have produced a return that was two percentage points higher than the benchmark.
Beta measures the risk of a fund by measuring the volatility of its past returns in relation to the returns of a benchmark.
For example, a fund with a beta of .7 versus the S&P 500 Index has experienced gains and losses that are 70% of the S&P 500 Index’s changes. A fund with a beta of 1.0 is expected to follow the moves of the index.
Sharpe Ratio measures return per unit of risk. The higher the Sharpe Ratio, the better the fund’s historical risk-adjusted performance.
It is calculated as return minus the risk free rate divided by standard deviation.
The Sharpe Ratio uses standard deviation which is ‘non directional’ meaning it does not differentiate between upside volatility or downside volatility. For example, a fund with monthly returns of -3% and +3% will have the same volatility as another fund that is flat one month and +6% the next. In this example, the Sharpe Ratio in effect punishes the second fund for better performance, even though most investors would obviously prefer the second fund over the first fund.
Sortino Ratio measures return per unit of ‘bad’ volatility by replacing the denominator in the Sharpe Ratio (standard deviation) with downside deviation. It provides a measure of the fund’s performance without penalizing it for upward swings in return. A large Sortino Ratio indicates a low risk of large losses occurring.
Treynor Index is a helpful measurement of the fund’s excess return from each unit of systematic risk. It measures the fund’s excess return (fund’s rate of return minus the risk free rate of return) per unit of risk using beta as the measure of risk as opposed to the standard deviation of the fund’s returns.
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