Alternative Beta Strategies and Hedge Fund Replication

4

Empirical Return and Risk Properties of Hedge Funds

There exists today a solid body of research on the empirical risk and return properties of hedge funds as well as the overall benefits investors receive by including them in their overall portfolios.¹ The various studies have applied a range of statistical measures: expected return, volatility, higher moments (skew and kurtosis), maximal draw-downs and various correlation attributes. This chapter restates and summarizes the results of these studies on the basis of given different hedge fund performance indices.² However, the financial industry has not yet found a clear consensus on what performance measures are most suitable to account for the complexity of hedge fund returns. Therefore I will begin the discussion with the issues involved in measuring that complexity.

4.1 WHEN THE SHARPE RATIO IS NOT SHARP ENOUGH

Hedge fund proponents often make their case by pointing out – besides their low correlations to traditional assets – hedge funds' attractive reward-to-risk characteristics. The most often mentioned measure of risk-adjusted performance is the ‘Sharpe ratio’, the ratio of annualized monthly returns (minus the benchmark risk-free return) and the annualized monthly volatility. Hedge funds' high Sharpe ratios support the claim that hedge funds have much lower risk than equity investments, while yielding similar levels of returns. However – more than equities – some hedge fund strategies show negative outbreaks exceeding ...