Evaluating Hedge Fund Performance

CHAPTER 5

Evaluating Hedge Fund Strategies

We now know that not all hedge funds are alike. They are a diverse group with vastly different investment strategies even within individual styles. Unlike traditional long-only strategies, which are dependent on the market or beta, hedge fund returns are purported to have low or zero correlation with the stock and bond markets, as they seek to generate positive returns even in market declines. As a result, hedge fund returns are said to be generated by manager skills and talents, or alpha.

The reality, however, is actually mixed. Hedge funds do not emphasize tracking the popular market benchmarks to generate returns. However, their strategies have been shown to be driven by certain market factors, including returns of the stock and bond markets, to a greater extent than indicated by correlation analysis. In this chapter we discuss the factors affecting returns of hedge fund strategies and their potential risks over and beyond the information obtained from correlation analysis and such measures as standard deviations of returns. This understanding will hopefully shed more light on the types of strategies that investors should or should not invest in.

WHICH STRATEGIES?

Hedge funds provide diversification benefits because of their reported low volatility of returns and low correlations with the traditional stock and bond markets, while producing Sharpe ratios superior to traditional bonds and equities. However, the benefits vary with strategies. ...