Hedge Fund Analysis: 4

Performance Metrics to
Consider

According to data by research firm Preqin, hedge funds

surpassed $4 trillion in assets under management at the
end of March 2021. This high-risk, high-reward asset
class is a notoriously esoteric investment option limited to
high-net-worth individuals and institutional investors.
Hedge funds use a wide variety of sophisticated
strategies, but they don’t have to be confusing.

Whether you’re an aspiring hedge fund manager, an

accredited investor looking to get started in the space, or
a curious professional hoping to understand hedge fund
analysis, gaining a foundation in the basics of hedge
funds and the metrics most commonly used to measure
their performance is a great place to start.
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What Are Hedge Funds?

Hedge funds are a type of alternative investment that use
pooled funds and various investment strategies to earn
returns for limited partners. Hedge funds’ investment
strategies can include virtually any investment type,
ranging from traditional assets, such as stocks and bonds,
to other types of alternatives, like private companies or
real estate. The primary goal of hedge funds is to realize a
return on investment no matter the market’s state.

Two key hedge fund strategies to know are:

Diversification, which requires building portfolios

that contain a variety of asset types and risk profiles
as a way to spread out risk and maximize potential
returns.
Hedging, which aims to limit risk by offsetting one
security’s risk with another. For example, to offset the
risk caused by an asset’s seasonal fluctuation, you
could invest in an asset with the opposite seasonality.
In this simplified example, the risk of these two
assets together is effectively zero.
Hedge funds require investors to be accredited, which is
defined by the United States Securities and Exchange
Commission (SEC) as having a net worth of at least $1
million or having had an annual income of $200,000 or
more ($300,000 or more with a spouse) for the past two
years with a reasonable expectation that it will extend to
the current year.

If you’re an accredited investor, you need a network of

connections in the field to get individually involved in
hedge fund investing.

Related: 3 Essential Skills for Success in the Alternative

Investments Industry

Foundations for Hedge Fund Analysis

Before learning about metrics for measuring hedge fund
performance, there’s necessary groundwork to lay. It can
be tempting to assume that if Portfolio A has a higher
return on investment than Portfolio B, Portfolio A was a
more successful investment. Yet, this doesn’t consider
each portfolio’s risk profile.

A decent return on a high-risk investment can be

considered more successful than a high return on a low-
risk investment. This is especially relevant when analyzing
hedge funds because this investment field is all about
offsetting risk and outperforming the market based on
well-managed securities combinations.
Basic statistical knowledge can be a helpful precursor to
hedge fund analysis, as performance is often measured
using averages, standard deviations, or ratios that are
calculated using statistical formulas.

Additionally, hedge fund analysis relies heavily on

benchmarking. Because the goal is to outperform the
market, your analysis needs a point of reference, or
benchmark. The metrics for measuring hedge fund
performance are based on various factors—including risk
and return—that are benchmarked against the S&P 500 or
other investment indices.

Related: The Future of the Alternative Investments

Industry

4 Performance Metrics for Hedge Fund

Analysis
To get involved in hedge funds, you need to understand
the ways you can measure their performance. Here’s a
primer on four of the most common performance
measures for hedge fund analysis.

1. Beta

Beta (β) is the measure of an asset or portfolio’s risk

compared to the market’s risk. If an asset has a beta of
one, its risk profile is the same as the market’s. There’s no
“good” or “bad” beta—it’s all about you or your client’s risk
preference. If you prefer safer investments, a portfolio
with a beta of 0.3—30 percent of the market’s risk—could
be a good choice. If you feel comfortable with a higher
level of risk, a portfolio with a beta of 1.3—130 percent of
the market’s risk—might be more attractive.

One way to obtain your desired beta level is to invest in

the market as a whole, giving equal weight to riskier and
safer investment options, then invest a percentage of your
capital to match your desired beta.

For instance, it’s explained in the online course Alternative

Investments that if you want a beta of 0.8, you could
simply invest 80 percent of your investment capital in the
market and keep the other 20 percent as cash, or invest it
in a risk-free asset, such as treasury bills. This ensures
that 80 percent of your investment will have the same
beta as the market, and the other 20 percent will have a
beta of zero.

The example also illustrates how you might obtain a beta

of 1.3: Invest all of your capital in the market (100 percent)
and then borrow the equivalent of 30 percent of your
initial investment and invest that in the market, too. Your
risk would then be equal to 130 percent of the market’s
risk.

2. Alpha

Although it may seem backward, beta sets the stage for

alpha. Alpha (α) is the difference between an asset or
portfolio’s return and a benchmark’s return, relative to the
amount of risk taken (beta). Essentially, alpha is the extra
return your asset or portfolio gains above and beyond the
market’s return.

Alpha is an important metric because it provides context.

It answers the question, “If the beta were equal to one,
how much better or worse did this asset perform than the
market?” Alpha accounts for risk, allowing you to directly
compare your asset’s returns with the market’s returns.

To calculate alpha, use this formula, where “A” refers to

your asset or portfolio:

αA = (Actual Excess Return)A – βA × (Actual Return on

Market)

Calculating alpha requires knowing the average market

risk premium and the returns on a riskless asset (beta of
zero). These figures allow you to calculate how much
above or below the expected amount the asset or
portfolio returned. Those numbers can then be used to
calculate alpha.

3. Sharpe Ratio

The Sharpe ratio—coined by William Sharpe, winner of

the Nobel Prize in Economics—is the return percentage
per unit of risk. The Sharpe ratio is useful for directly
comparing the performance of two assets or portfolios
with different levels of risk.

Like alpha, the Sharpe ratio measures performance in

relation to risk, but instead of comparing the asset to the
market, it compares multiple assets to each other.

To calculate the Sharpe of a pair of assets, use this

formula:

Sharpe Ratio = (Return of Asset – Risk-Free Return) /

Standard Deviation of Asset’s Rate of Return

To use this formula, you need to know the return of your

asset, the rate of return on a risk-free asset, and the
standard deviation of your asset’s rate of return.
Standard deviation, one way to measure risk, is the
dispersion of a dataset based on its average. This basic
statistical concept can explain the range of possibilities in
both directions of the average. The larger the standard
deviation, the more risk involved.

An example of the Sharpe ratio in action can be found in

Alternative Investments, where two risky assets are
described: Investment A returns eight percent with a 20
percent standard deviation, and Investment B returns nine
percent with the same standard deviation. In this scenario,
it’s clear which asset you’d prefer: Investment B, because
it returns more than Investment A with the same level of
risk.

Things get trickier when assets’ risk levels are different.

Imagine now that Investment A returns eight percent with
a 10 percent standard deviation instead of 20 percent. Is
Investment B still the better performing asset? For this
example, assume the risk-free rate of return is two
percent.

Sharpe Ratio = (Return of Asset – Risk-Free Return) /

Standard Deviation of Asset’s Rate of Return

Calculation for Investment A:

Sharpe ratio = (0.08 - 0.02) / 0.1

Sharpe ratio = 0.06 / 0.1

Sharpe ratio = 0.6

Calculation for Investment B:

Sharpe ratio = (0.09 – 0.02) / 0.2

Sharpe ratio = 0.07 / 0.2

Sharpe ratio = 0.35

After calculating the Sharpe ratio of the two assets, it’s

clear that Investment A is the better performing
investment.

4. Information Ratio

The information ratio is the excess return of an asset or

portfolio divided by its “tracking error,” which is the
standard deviation of the fund’s excess returns (or alpha).
Similar to the Sharpe ratio, the information ratio measures
return per unit of risk but focuses on excess returns
instead of total returns.

To calculate the information ratio, use this formula:

Information Ratio = (Asset Rate of Return –

Benchmark Rate of Return) / Alpha

The information ratio can be used to tell if the risk of

trying to outperform the market is worth it. If your
information ratio is high, your strategies are more likely to
pay off.

Building on Foundational Analysis

Skills
These foundational concepts and metrics are just the tip
of the hedge fund iceberg. If you’re interested in investing
in hedge funds or becoming a portfolio manager, starting
with the basics can provide a strong foundation on which
to build your knowledge. It’s important to remember that
each metric considers how an asset or portfolio relates to
its benchmark and weighs the risk involved, but each
provides a unique perspective on performance.

To learn more about hedge fund performance metrics,

how they influence each other, and how to build a
diversified portfolio, consider taking an online course,
such as Alternative Investments.

Are you interested in expanding your knowledge of

hedge funds and other alternative investments?
Explore our five-week online course Alternative
Investments and other finance and accounting
courses.