Evaluating novel hedge fund performance measures under different economic conditions / Francois van Dyk

by Francois Van Dyk

Institution: North-West University
Year: 2014
Keywords: Hedge fund; Risk management; Performance measurement; Risk-adjusted performance; Scaled performance measure; Sharpe ratio; Bias ratio; Omega ratio; Treynor ratio
Record ID: 1411668
Full text PDF: http://hdl.handle.net/10394/13443


Performance measurement is an integral part of investment analysis and risk management. Investment performance comprises two primary elements, namely; risk and return. The measurement of return is more straightforward compared with the measurement of risk: the latter is stochastic and thus requires more complex computation. Risk and return should, however, not be considered in isolation by investors as these elements are interlinked according to modern portfolio theory (MPT). The assembly of risk and return into a risk-adjusted number is an essential responsibility of performance measurement as it is meaningless to compare funds with dissimilar expected returns and risks by focusing solely on total return values. Since the advent of MPT performance evaluation has been conducted within the risk-return or mean-variance framework. Traditional, liner performance measures, such as the Sharpe ratio, do, however, have their drawbacks despite their widespread use and copious interpretations. The first problem explores the characterisation of hedge fund returns which lead to standard methods of assessing the risks and rewards of these funds being misleading and inappropriate. Volatility measures such as the Sharpe ratio, which are based on mean-variance theory, are generally unsuitable for dealing with asymmetric return distributions. The distribution of hedge fund returns deviates significantly from normality consequentially rendering volatility measures ill-suited for hedge fund returns due to not incorporating higher order moments of the returns distribution. Investors, nevertheless, rely on traditional performance measures to evaluate the risk-adjusted performance of (these) investments. Also, these traditional risk-adjusted performance measures were developed specifically for traditional investments (i.e. non-dynamic and or linear investments). Hedge funds also embrace a variety of strategies, styles and securities, all of which emphasises the necessity for risk management measures and techniques designed specifically for these dynamic funds. The second problem recognises that traditional risk-adjusted performance measures are not complete as they do not implicitly include or measure all components of risk. These traditional performance measures can therefore be considered one dimensional as each measure includes only a particular component or type of risk and leaves other risk components or dimensions untouched. Dynamic, sophisticated investments – such as those pursued by hedge funds – are often characterised by multi-risk dimensionality. The different risk types to which hedge funds are exposed substantiates the fact that volatility does not capture all inherent hedge fund risk factors. Also, no single existing measure captures the entire spectrum of risks. Therefore, traditional risk measurement methods must be modified, or performance measures that consider the components (factors) of risk left untouched (unconsidered) by the traditional performance measures should be considered alongside traditional performance…