(July 13, 2012) — Hedge fund performance may soon be measured relative to the end investor’s risk tolerance, as a new method to do so has been published by a leading European research unit.
The EDHEC-Risk Institute has published a paper illustrating the failings of current performance measurement of hedge funds and offers an alternative. It said that the wide range of investment strategies in the hedge fund sector made it difficult to benchmark outperformance by individual firms.
The study added that risk tolerance amongst investors also varied significantly, and this was to be considered when plotting out a fund’s results.
The report said: “A main drawback of the current approaches is to relate hedge fund returns to such risk factors linearly since it has been shown that hedge fund returns exhibit complex nonlinear exposures to traditional asset classes. In this paper, we propose a new method that captures the complex nonlinear exposures of a hedge fund strategy to several risk factors.”
In addition to measuring asset class exposure in a different way to the method used to benchmark traditional fund managers, the EHDEC proposal produces a risk adjustment function that weights hedge fund returns depending on the risk tolerance of an investor.
In this regard, the institute found that altering the risk tolerance of an investor affected the production of alpha in varying degrees according to the asset class.
Reducing the investors’ risk tolerance in emerging markets hit alpha production significantly, whereas equity hedge and macro funds were relatively unaffected.
Conversely, funds with a short-bias or those invested in Asia saw alpha generation rise as risk tolerance was reduced.
“These findings strongly suggest that what was incorrectly measured as hedge fund alpha in previous studies is actually some form of fair reward obtained by hedge fund managers from holding a set of relatively complex linear and nonlinear exposures with respect to various risk factors. Often the reduction in performance comes from a small number of extreme events which are not captured well with the usual linear approach.”
The authors of the report said the approach could be extended to evaluate hedge fund managers’ performance within specific macroeconomic environments such as high or low interest-rate states, large or limited economic uncertainty, boom or bear markets, liquid or illiquid markets. This, the paper said, would make performance measurement more transparent to general economic conditions.
Click here for the full paper.