By Dan Barufaldi

If you read the description of most hedge fund investment objectives, there is usually some mention of absolute returns. It is this goal that makes hedge funds so attractive, particularly when markets are down. Unlike mutual funds, which constantly measure themselves against their appropriate benchmarks and comment on their performance versus their benchmarks, hedge funds promise – and are intended – to provide absolute returns regardless of market conditions. That being said, there are always market movements that affect hedge fund performance, either directly or indirectly (via the impact on their underlying investments).

In this section of the tutorial, we'll introduce you to some basic performance measurement techniques for analyzing hedge funds. I cannot stress enough that this process and the due diligence process mentioned in a later section of this tutorial are not sufficient to justify an investment. The entire hedge fund evaluation process goes beyond the scope of this tutorial and encompasses a much deeper level of analysis than what we can cover here.

Absolute Returns
A hedge fund must be evaluated based on absolute returns, but those returns also need to be consistent with the fund's strategy. There are funds that employ strategies that generate very consistent returns over time with limited volatility. An example of this type of fund is an asset-backed lending fund that makes loans and collects payments that are predictable and consistent over time. These funds can generate anywhere from 8-12% per year and are often used as a substitute for fixed income when fixed income is not attractive.

There are other fund strategies that should have similar returns and there are also strategies that should generate higher returns, albeit with much higher volatility. In either case, a hedge fund that describes its strategy as pursuing absolute returns should always have positive returns over 12-month periods, for example. Most hedge funds fall short of these expectations, but in a perfect world, absolute returns should be positive and consistent.

The Sharpe Ratio
One metric that is widely used in the hedge fund world is the Sharpe ratio. The Sharpe ratio measures the amount of return adjusted for each level of risk taken. It is calculated by subtracting the risk-free rate from annualized returns and dividing the result by the standard deviation of the returns. This metric can be applied across hedge funds with different levels of returns and volatility to determine whether the hedge fund is generating any alpha (excess return) by taking on additional risk. A good Sharpe ratio will vary by strategy and anything above 1 tends to be an attractive return. As with other measures, however, the following analyses should be conducted using Sharpe ratio as well as pure returns metrics. (For further reading, see Understanding The Sharpe Ratio and The Sharpe Ratio Can Oversimplify Risk.)

Benchmarks
A very common analysis, and one that is prevalent in the mutual fund world, is to analyze relative returns versus a benchmark. For example, a large-cap manager would be compared to the S&P 500 Index, and his or her performance would be evaluated based on the fund's returns and standard deviation relative to the index. For hedge funds, the relative performance analysis is more challenging but not impossible.

There are a variety of hedge fund indexes that are broken down by strategy in addition to a few aggregate indexes that measure combinations of strategies. The following are those listed by Hedge Fund Research:

Hedge Fund Strategy Classifications
Equity Hedge Even Driven Macro Relative Value
Equity Market Neutral Merger Arbitrage Discretionary Thematic Fixed Income - Convertible Arbitrage
Fundamental Growth Special Situations Systematic Diversified Fixed Income - Asset Backed
Energy/Basic Materials Activist Systematic Commodity Volatility
Technology / Healthcare Private Issue / Regulation D Multi-Strategy Yield Alternatives
Short Bias Credit Arbitrage -- Multi-Strategy
Quantitative Directional Multi-Strategy -- --
Multi-Strategy -- -- --
Source: Hedge Fund Research, 2008.

Although most hedge fund marketing materials compare themselves to the S&P 500 to display their outperformance and uncorrelated returns, as investors, we have to understand if the manager is doing well relative to other hedge funds using the same or similar strategies. The first step in this process is to gain enough of an understanding of the hedge fund manager's style in order to determine which hedge fund index, if any, their performance can be compared to. (Learn how this strategy relates to mutual funds in How's Your Mutual Fund Really Doing?)

As mentioned in the section on strategies, many strategies can be categorized into certain buckets, but each fund has a unique strategy. In many cases, some hedge funds may have multiple strategies, making the index decision more difficult. Let's evaluate a simple example: Suppose we are evaluating a long/short equity fund that focuses on event-driven opportunities such as mergers, management buyouts, share buybacks or any other events. There is both a long/short equity index and an event-driven index, and the obvious solution is to run a comparison to both. We could evaluate whether the hedge fund's performance is more like one index than the other. If the fund compares well versus both indexes, however, then additional due diligence is warranted. If the fund compares poorly, then the due diligence process may end there.

Once a hedge fund passes the index test, we could then get more specific in our comparisons by evaluating the hedge fund performance versus peers that use similar strategies. The first level of peer analysis would be a comparison of returns versus other hedge fund managers that state they apply the same strategy. Most databases group hedge funds into categories, which are closely related to the hedge fund indexes mentioned above. However, unlike the hedge fund index, which may only have a limited number of funds, choosing all the funds in a category gives the analysis a much broader perspective and allows the analyst to place the fund in quartiles relative to peers.

Quartile Chart
This analysis can go even deeper and become more sophisticated by carefully evaluating funds and including in the peer analysis only those funds with the most comparable strategies. The number of these hedge funds would be smaller than if using the database categories, but will give the analyst a much better idea of how this fund compares to others.

In the peer analysis, we are looking for hedge funds that consistently perform in the top quartile of their peers on an absolute return comparison, standard deviation, and a variety of other metrics relevant to the analysis. We are looking for performance relative to peers during certain market cycles, as well as performance over short and long periods of time. After all, if a fund manager cannot consistently outperform his or her peers, then chances are we are better served investing in some of the better-performing peers, or, in cases where investing in a hedge fund index is possible, investing in a well-diversified index of funds using a certain strategy. (Learn more in Quantitative Analysis Of Hedge Funds and Peer Comparison Uncovers Undervalued Stocks.)

Conclusion
Evaluating hedge fund performance differs significantly from the analysis used in other investments because of their risk/return characteristics and unique strategies. Robust analytical software will provide not only the metrics mentioned above, but also a variety of other metrics that can add insight into the performance of a particular fund. The list of metrics can be endless and every analyst tends to gravitate toward a group of select favorites that provide enough information to determine whether due diligence should continue.

The further along a fund gets in the due diligence process, the more likely other metrics will be considered and analyzed. Keep in mind that one can analyze any fund to the point of finding something wrong with it and that this is not the goal. Instead, investors should strive to understand metrics well enough to properly evaluate a portfolio.

Next: Hedge Funds: Risks »


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