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

Understanding Historical Returns, Normality, Portfolio Sensitivity, and Data Bias

Performance attribution analysis is the decomposition of an investment's performance into its component parts. Performance can be attributed to asset classes, currencies, sectors, industries, geographies, commodities, economic variables, specific stocks or bonds, indices, benchmarks, or factors that explain the returns of an investment or a fund over a period of time.

Evaluating hedge fund performance requires an understanding of some basic terms that are unique to the investment management business and hedge fund investing. Once the definitions and calculations associated with performance measurement are mastered, an investor can begin to assess the implications and meaning of the similarities or differences in reported results between managers or peer groups.

Most managers provide monthly return information to investors that can be used to calculate some of the variables discussed here. In other cases, such as the analysis of a portfolio's duration, beta or credit spread exposure, or sensitivity analysis, the manager or a third-party risk provider needs to provide investors with the information since it is based on the underlying portfolio itself and not just the monthly fund returns.

Historical Returns

The first piece of information most investors want to know about a particular fund that is within a strategy under consideration is the fund's historical return. The historical return includes the ...