Evaluating Hedge Fund Performance

CHAPTER 8

Evaluating the Performance of Your Hedge Funds

In assessing hedge funds' performance, not only rates of return are important, but risks, or, more accurately, changes in the risk profiles of the funds, are crucial. Among funds of funds, it is a well-known practice that sometimes a fund is terminated after a period of generating extraordinarily large gains. In traditional investing, such results would be lauded as exceptional talent. In contrast, a fund of funds manager might look at such instances as signs that the hedge fund managers were taking exceptional risks.

As a result of the evaluation of performance and reassessment of the risk profiles, the underperforming funds would be shed. At this time, the cash raised from redemptions from poorly performing funds may be reinvested in new funds, or simply new investments need to be made. Accordingly, new managers need to be identified and selected and portfolio construction issues arise regarding the risk and return to be expected from the newly reconfigured portfolio. For investors who are active in hedge fund investing, the three-step process of manager evaluation, portfolio construction, and monitoring are continuous, overlapping, and integral.

HOW WELL IS YOUR HEDGE FUND PORTFOLIO?

Most individual investors who invest in stocks and bonds would be happy if their investment advisers produce a 20 percent return when the stock market goes up by, say, 25 percent, and they would be content even if their accounts increase somewhat ...