Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Measuring Performance

Hedge funds provide investors with periodic reports of their returns and their risk profile, either directly or via a third-party service provider or database. There are no standard methodologies that are mandated, and many forms of reporting and aggregation have limited value, are misleading, or are not accurate. Fund performance is generally reported on a monthly basis and is calculated net of all fees. Some of the basic values reported to an investor are those related to the fund's returns, volatility, and fund exposure.

Arithmetic and Geometric Mean Returns

The average monthly return is simply the sum of all monthly returns in a reporting period divided by the number of periods. A fund generating 2 percent, 4 percent, 2 percent, and 1 percent would have an arithmetic mean of 2.25 percent per month and a 27 percent annualized return.

The geometric mean or compound annual growth rate is the rate of return that equates the beginning value to the ending value of an investment over the number of periods of the investment. A fund generating 2 percent, 4 percent, 2 percent, and 1 percent would have a geometric mean that is slightly lower at 2.24 percent per month and a return that is slightly higher at 30 percent. Another term that is synonymous with the geometric mean is the compound annual growth rate (CAGR).

Funds should normally use the geometric mean or CAGR when reporting results to an investor; however, this may not always be the case. The formula to compute ...