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Measuring Hedge Fund Returns

Preqin

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Hedge funds offer unique return opportunities compared to traditional investments in stocks and bonds. As hedge funds have low correlation to other asset classes and employ hedging strategies, they are expected to generate positive returns regardless of market direction. So, what does this mean for hedge fund performance?

Measuring Hedge Fund Performance

Hedge fund managers use a variety of performance measures and statistics when reporting hedge fund performance to current and prospective investors. Some key methods for measuring performance include:


1. Cumulative performance

Cumulative performance is calculated as the aggregate percentage change in a fund’s net asset value (NAV) over a given timeframe. The cumulative performance is typically measured over trailing periods such as the past three months, one year, three years, or five years. It is also commonly measured for individual years, the current calendar year (YTD) and the entire period since a fund’s inception.

Monthly returns can also be calculated in a similar manner, by looking at the percentage change in the fund’s month-end NAV from the previous month-end NAV, after fees have been deducted. Net-of-fees returns are used to provide an indication of fund performance from the perspective of investors.



2. Sharpe ratio

When evaluating performance, it is important to consider the risks taken by the fund. A fund with the same returns as another but with much lower risk (as measured by standard deviation of returns), and all other things being equal, would be a preferable choice for an investor portfolio. This logic also applies to a fund that is achieving higher returns than another, while exhibiting the same level of volatility.

The Sharpe ratio provides an indication of a fund’s returns relative to its level of risk. This is calculated by subtracting a predetermined risk-free rate from the fund’s annualized return to generate the fund’s excess return, then dividing by the fund’s volatility over the same period. In general, the higher the Sharpe ratio, the better the risk/reward characteristics of a fund. A Sharpe ratio greater than 1.0 effectively means that the fund has earned more than one unit of return for each unit of risk taken.



3. Sortino ratio

The Sortino ratio provides an indication of a fund’s returns relative to its level of downside risk only. It is similar to the Sharpe ratio, but the Sharpe ratio can be negatively affected by volatility on the upside, as well as on the downside. In contrast, the Sortino ratio assumes that investors are tolerant of volatile returns if gains are being made. This is calculated as a fund’s excess return (annualized return minus a predetermined minimum acceptable return) divided by its downside deviation below the minimum acceptable return.



4. Drawdown 

Another measure used to evaluate hedge fund performance is drawdown, which represents the largest decline in a hedge fund’s performance from high to low. Drawdown is calculated as the difference between a fund’s high-water mark and the low point following this high-water mark.

The severity and duration of the drawdown period is an important factor in evaluating hedge fund performance as investors often rely on hedge funds to provide downside protection when traditional asset classes are experiencing losses. Drawdown measurements are also useful in helping investors to anticipate future downturns. Some funds, such as tail-risk hedge funds, will experience long stretches of underperformance punctuated by sharp, significant reversals into profitability.

Benchmarking Hedge Fund Returns

Traditional equity or fixed income performance is often evaluated by comparing the returns against an industry benchmark. This makes it possible to determine how much value the manager has added to the fund over what could have been achieved by investing in the benchmark fund.

Performance evaluation for hedge funds is more difficult since they tend to target absolute returns, rather than relative returns. Hedge fund performance benchmarks therefore work slightly differently. Rather than comparing against industry benchmarks, hedge fund performance benchmarks will typically comprise a group of peer funds, or against a portfolio that has similar characteristics to the hedge fund portfolio being evaluated. If a suitable benchmark can be found, alpha is estimated as the manager’s return above the benchmark return.

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Hedge Fund Risk/Return Profiles

Unlike traditional, long-only mutual funds, hedge funds are free to engage in what are often seen as ‘risky’ techniques, such as using derivatives, leverage, or short selling. These methods are intended to improve the risk/reward ratio of the fund’s investments during market downturns.

Historically, hedge funds were set up as absolute return vehicles, targeting high returns under all market conditions. Over time, their role in aggregate has changed, as institutional investors have become more sophisticated in their knowledge and use of alternative assets. Many investors now use hedge funds to reduce risk in their portfolio (i.e. as a return diversifier), with other alternative assets (such as private equity) now complementing these funds in their role as a long-term return-enhancer.

The risk/reward profile of hedge funds varies drastically by strategy. For example, an equity market neutral fund will have very little exposure to market movements, so returns will depend almost exclusively on the fund manager’s skill in selecting securities. Compared to an equity fund with a sizable long bias, the equity market neutral fund will act more as a portfolio diversifier, rather than a return-enhancer. By contrast, global macro funds are likely to offer a vastly different risk/reward profile, generating returns based on the fund manager’s view of macroeconomic policy, political events, or currency fluctuations.

Niche hedge fund strategies such as cryptocurrency funds, insurance-linked strategies, and litigation finance funds offer an alternative to the strategies within long/short equity, merger arbitrage, or global macro. These funds have different risk exposures and exhibit low correlation to traditional markets, mirroring the original hedge fund structure.

By introducing hedge funds to a portfolio of traditional equity investments (represented by the S&P 500 PR Index in the below chart) an investor should be able to improve the Sharpe ratio of the overall portfolio, assuming low correlation between the two. The chart shows how the risk/return profiles for hedge funds vary by strategy.

In this lesson, we explored the many ways in which the performance of a hedge fund can be measured. As you now know, hedge funds provide unique opportunities for returns, outside of the traditional returns seen in the public markets with stocks and bonds. From cumulative performance and the Sharpe ratio to the Sortino ratio and drawdowns, you’re now familiar with the measurements used by industry participants. With more insight into benchmarking and how the ‘riskier’ techniques impact returns across strategies, we’ve uncovered the benefits of investing in a hedge fund.