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.

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.

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 that 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.

Related Readings:

Standard Deviation & Value At Risk

Related Articles
  1. Investing

    Are Hedge Funds Chasing Performance?

    Learn why hedge funds have performed worse than the S&P 500 Index in 2016, and why they may overweight equities to play catch-up in the second half of 2016.
  2. Financial Advisor

    Why Hedge Funds Are Not Living Up to Return Hype

    Hedge funds are supposed to produce better returns while protecting your investments from the downside. Here's why they are not living up to their purpose.
  3. Investing

    Hedge Funds Go Retail

    Find out how average investors are breaking into what was once reserved for the ultra rich.
  4. Investing

    What Are Hedge Funds?

    Hedge funds may be similar to mutual funds in some ways, but they differ in other ways like fee structure. Is a hedge fund for you?
  5. Investing

    Evaluating Hedge Fund Performance

    Most investors are aware of hedge funds, but many don't know the dirty details of this unique investment type.
  6. Investing

    Taking A Look Behind Hedge Funds

    Hedge funds can draw returns well above the market average even in a weak economy. Learn about the risks.
  7. Investing

    Hedge Funds' Higher Returns Come At A Price

    Learn how hedge funds win big gains for investors - and why they sometimes lose.
  8. Investing

    3 Things Divorcees With Hedge Fund Investments Should Know

    Hedge funds are assets that can be very difficult to divide during a divorce.
  9. Investing

    Hedge Funds Hunt For Upside, Regardless Of The Market

    Hedge funds seek positive absolute returns, and engage in aggressive strategies to make this happen.
  10. Investing

    Just How Different Are Hedge Fund Investing Strategies?

    Before investing in hedge funds, be sure to consider all the facts.
Frequently Asked Questions
  1. How did the ABX index behave during the 2008 subprime mortgage crisis?

    Read about the disastrous performance of the various ABX indexes in the subprime mortgage crisis of 2008 during the middle ...
  2. How did moral hazard contribute to the 2008 financial crisis?

    Learn about moral hazard, how it can affect outcomes and how it contributed to the conditions that led to the 2008 financial ...
  3. Which mutual funds made money in 2008?

    Read about the only mutual fund that turned a profit in 2008. Learn about risk-averse investment strategies and the financial ...
  4. Were Collateralized Debt Obligations (CDO) Responsible for the 2008 Financial Crisis?

    Collateralized debt obligations are exotic financial instruments that can be difficult to understand, Learn the role they ...
Trading Center