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

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