Standard Deviation
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?"



Downside Capture, Drawdown And Leverage

Related Articles
  1. Managing Wealth

    Standard Deviation

    Learn about how standard deviation is applied to the annual rate of return of an investment to measure the its volatility.
  2. Investing

    Why Standard Deviation Should Matter to Investors

    Think of standard deviation as a thermometer for risk, or better yet, anxiety.
  3. Investing

    Quantitative Analysis Of Hedge Funds

    Hedge fund analysis requires more than just the metrics used to analyze mutual funds.
  4. Trading

    How To Convert Value At Risk To Different Time Periods

    Volatility is not the only way to measure risk. Learn about the "new science of risk management".
  5. Investing

    Explaining the Empirical Rule

    The empirical rule provides a quick estimate of the spread of data in a normal statistical distribution.
  6. Investing

    PRHSX: Risk Statistics of Health Sciences Mutual Fund

    Examine the risk metric of the T. Rowe Price Health Sciences Fund. Analyze beta, capture ratios and standard deviation to assess volatility and systematic risk.
  7. Trading

    Trading With Gaussian Models Of Statistics

    The entire study of statistics originated from Gauss and allowed us to understand markets, prices and probabilities, among other applications.
  8. Trading

    Improve Your Investing With Excel

    Excel is a useful tool to assist with investment organization and evaluation. Find out how to use it.
  9. Investing

    A Simplified Approach To Calculating Volatility

    Though most investors use standard deviation to determine volatility, there's an easier and more accurate way of doing it.
  10. Investing

    Understanding The Sharpe Ratio

    This simple ratio will tell you how much that extra return is really worth.
Frequently Asked Questions
  1. What is the difference between yield and return?

    While both terms are often used to describe the performance of an investment, yield and return are not one and the same ...
  2. What are the Differences Among a Real Estate Agent, a broker and a Realtor?

    Learn how agents, realtors, and brokers are often considered the same, but in reality, these real estate positions have different ...
  3. What is the difference between amortization and depreciation?

    Because very few assets last forever, one of the main principles of accrual accounting requires that an asset's cost be proportionally ...
  4. Which is better, a fixed or variable rate loan?

    A variable interest rate loan is a loan in which the interest rate charged on the outstanding balance varies as market interest ...
Trading Center