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).

Hedge funds lie at the active end of the investing spectrum as they seek positive absolute returns, regardless of the performance of an index or sector benchmark. Unlike mutual funds, which are "long only" (make only buy-sell decisions), a hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (borrowing) to enhance the risk/reward profile of their bets.

This activeness of hedge funds explains their popularity in bear markets. In a bull market, hedge funds may not perform as well as mutual funds, but in a bear market - taken as a group or asset class - they should do better than mutual funds because they hold short positions and hedges. The absolute return goals of hedge funds vary, but a goal might be stated as something like "6 to 9% annualized return, regardless of the market conditions."

Investors, however, need to understand that the hedge fund promise of pursuing absolute returns means hedge funds are "liberated" with respect to registration, investment positions, liquidity and fee structure. First, hedge funds in general are not registered with the SEC. They have been able to avoid registration by limiting the number of investors and requiring that their investors be accredited, which means they meet an income or net worth standard. Furthermore, hedge funds are prohibited from soliciting or advertising to a general audience, a prohibition that lends to their mystique.

It is useful to understand some of the common terms associated with hedge fund performance. Understanding these terms provides insight into how the investments work and how to evaluate them.



Absolute Returns & The Sharpe Ratio

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