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.

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:

α_A = (Actual Excess Return)_A – β_A × (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.

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. Do you want to build your financial fluency? Download our free Financial Terms Cheat Sheet.