Handbook of Hedge Funds

18

Measuring Net Asset Values and Returns

Remember that a stock that fell by 90% is a stock that felt by 80% and then halved.

The two basic factors to be weighted in investing, risk and return, are obviously the opposite sides of the same coin. Each must be measured to assess and understand past performance, and convince investors that their money is in the right hands. Both must also be predicted in order to make intelligent investment decisions for the future. Of course, we all know that the future is uncertain and that history may not repeat itself, but understanding what happened in the past is likely to be a guide in formulating expectations about what may happen in the future.

Measuring the ex-post return and risk of an investment may sound somewhat trivial. However, the number of hedge fund managers claiming that their fund has superior risk-adjusted returns and belongs to the top quartile often amazes me, particularly when we simultaneously hear the dissatisfaction of investors and the tentative explanations of consultants. The reason for this discordance is simply the lack of standards on how to measure risk and return, the multidimensionality of hedge fund returns in terms of descriptive statistics, and the lack of agreement on what constitutes an appropriate benchmark. Today, the hedge fund industry is so diverse that it is impossible to define a small number of sectors that are homogeneous enough to ensure apples-with-apples comparisons.

In the traditional investment ...