A number of factors affect performance evaluation for hedge funds, particularly with respect to using the Sharpe ratio to measure risk-adjusted return.
Starting with return, typically monthly returns are compounded to an annualized rate of return. However, entry and exit opportunities may be permitted only quarterly or even less frequently. In addition, some measures of downside risk such as the maximum drawdown are not compounded. Measures comparing return (compounded) and drawdown (not compounded) may not fully reflect the risk/return profile.
The Sharpe ratio is defined as:
- Numerator is the difference between annualized return and the annualized risk-free rate
- Denominator is the annualized standard deviation of returns
The Sharpe ratio increases proportionately with the square root of time, and is not appropriate when returns are asymmetrical. In particular, the Sharpe ratio tends to be overestimated when returns are serially correlated or assets are illiquid. Furthermore, the correlations between the fund and an investor’s other portfolio assets are not considered.
There are a number of ways managers can “game” the Sharpe ratio, including:
- Lengthening the measurement interval
- Compounding monthly returns but calculating standard deviations without compounding
- Writing out of money put or call options to produce asymmetric returns
- Smoothing returns
- Using swaps to eliminate extreme outlying returns
In part because of these deficiencies, the Sharpe ratio has not been found to be a good predictor of hedge fund returns.For more information, see all articles on: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Investment Returns, Portfolio Management See also: