Evaluating Hedge Fund Performance

PART Two

Evaluating and Selecting Hedge Funds

In Part One we discussed the misconceptions about long-term investing and diversification in asset allocation and how hedge funds can fill the void left open by traditional long-only investments to achieve long-term investment objectives with lower volatility. But hedge funds are not for everyone, and much needs to be investigated beneath the surface of impressive claims and statistics expressed in Greek letters. Though hedge fund managers will likely not agree that “[m]aybe hedge funds aren't so different from the market after all,”¹ the risk and return characteristics of hedge funds are not well understood, sometimes even by those who manage or sell them to investors. This is partly because return and risk data on hedge fund indexes are rife with flaws and questions. The analytical tools that have often been used to assess hedge fund risks are also not adequate to fairly estimate their potential risks. For hedge funds to be properly and effectively evaluated, it is therefore essential to seek a better understanding of the risk characteristics and the limits of the return potential of hedge funds. These issues will be the subjects of Chapter 4. Chapter 5 deals with evaluating hedge fund strategies. In Chapter 6, the focus is on the analysis, evaluation, and selection of individual hedge funds. The selected hedge funds then need to be assembled so as to produce the targeted returns and risks. This will be discussed in Chapter 7.

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