Handbook of Hedge Funds

20

Risk-Adjusted Performance Measures

If you cannot measure it, then you cannot manage it.

Most comparisons of hedge funds concentrate exclusively on total return figures. They openly ignore risk measures and risk-adjusted performance and claim to care only about absolute returns. Even worse, they provide no means of establishing the extent to which good past performance has been due to chance as opposed to skill. Nevertheless, these comparisons are widely used by marketers to show that their funds are superior to the competition. A 50% return over one year sounds better than 10%. Needless to say, if the funds or indices in question exhibit different risk characteristics, naive comparisons of this nature become extremely misleading. Investors who rely solely on returns to pick a hedge fund may not be prepared for the wild ride that lies ahead. Investing is by nature a two-dimensional process based not only on returns, but also on the risks taken to achieve those returns. The two factors are, however, opposite sides of the same coin, and both should be taken into consideration in order to make sound investment decisions.²⁰¹

Comparing funds that have the same risk characteristics or the same return characteristics is straightforward: at equal risk, more return is always better; at equal return, less risk is always preferable. Difficulties start when we have two or more funds with different expected returns and risks. In particular, given that a higher expected return is desirable ...