Hedge Funds - Standard Deviation & Value At Risk
The most common risk measure used in both hedge fund and mutual fund evaluations is standard deviation. Standard deviation in this case is the level of volatility of returns measured in percentage terms, and usually provided on an annual basis. Standard deviation gives a good indication of the variability of annual returns and makes it easy to compare to other funds when combined with annual return data. For example, if comparing two funds with identical annualized returns, the fund with a lower standard deviation would normally be more attractive, if all else is equal.
Unfortunately, and particularly when related to hedge funds, standard deviation does not capture the total risk picture of returns. This is because most hedge funds do not have normally distributed returns and standard deviation assumes a bell-shaped distribution, which assumes the same probability of returns being above the mean as below the mean.
Figure 2: Standard Deviation Chart
Most hedge fund returns are skewed in one direction or another and the distribution is not as symmetrical. For this reason, there are a number of additional metrics to use when evaluating hedge funds and, even with the additional metrics, some risks simply cannot be measured.
Another measure that provides an additional dimension of risk is called value-at-risk (VaR). VaR measures the dollar-loss expectation that can occur with a 5% probability. In Figure 2, this is the area to the left of the vertical black line on the left of the graph. This provides additional insight into the historical returns of a hedge fund, because it captures the tail end of the returns to the down side. It adds another dimension because it makes it possible to compare two funds with different average returns and standard deviation. For example, if Fund A has an average return of 12% and a standard deviation of 6%, and Fund B has an average return of 24% with a standard deviation of 12%, VaR would indicate the dollar amount of loss that is possible with each fund with a 5% probability.
Put another way, VaR would tell you with 95% confidence that your losses would not exceed a certain point. (You can never be 100% confident that you won't lose an entire investment.) It tries to answer the question "Given an investment of a particular return and volatility, what's the worst that could happen?"