When an allocator reviews a hedge fund, the first thing it usually sees is a one-page summary: monthly returns, annual returns, and a handful of risk figures such as volatility, Sharpe ratio, maximum drawdown and beta. Investor relations teams produce these figures, administrators supply the NAVs they are built from, and analysts compare them across managers.
Each figure answers a different question. How much did the fund make? How bumpy was the ride? How bad did it get? How much of the return came from the market rather than the manager? This lesson works through each one using the Kessling Harbor Equity Long/Short Fund, then looks at why the numbers can make a fund look safer than it is.
Returns
A hedge fund's return is the change in its NAV per share over a period, usually shown net of fees: after management and performance fees (lesson 3.3) and fund expenses. Net returns are what investors actually earn, so compare net with net.
Returns are usually reported monthly, because the administrator calculates NAV monthly, and then combined into year-to-date, annual and since-inception figures.
Returns combine by compounding, not by adding. If a fund gains 10% one month and 10% the next, $100 becomes $110 and then $121: a 21% gain, not 20%. Compounding also works against investors after losses. A fund that falls 20% and then rises 20% is down 4% overall, because the rise is on a smaller balance.
Two other points to check:
- Which share class? Classes with different fees or currencies have different returns (lesson 3.1).
- Annualized or not? A return for a period longer than a year is often shown annualized: the steady yearly rate that would have produced the same cumulative result.
Volatility and the Sharpe ratio
Volatility measures how much returns bounce around. It is the standard deviation of the fund's returns: roughly, the typical distance of each return from the average. It is usually calculated from monthly returns and then converted to an annual figure.
Two funds with the same average return can have very different volatility. Both of these illustrative funds average 1.0% a month:
| Month | 1 | 2 | 3 | 4 | 5 | 6 | Average |
|---|---|---|---|---|---|---|---|
| Fund A | +1.0% | +0.5% | +1.5% | +1.0% | +0.5% | +1.5% | +1.0% |
| Fund B | +4.0% | −3.0% | +5.0% | −2.0% | +3.0% | −1.0% | +1.0% |
Fund B's returns swing much further from the average, so its volatility is far higher. Higher volatility is not bad in itself, but it means a wider range of outcomes for the investor.
The Sharpe ratio puts return and volatility together. It asks how much return the fund earned above a risk-free investment, per unit of volatility:
Sharpe ratio = (return − risk-free rate) ÷ volatility
The risk-free rate is what an investor could earn with almost no risk, usually measured by a short-term government bill rate. Return above it is the reward for taking risk.
Suppose Kessling Harbor returned 8% last year, the risk-free rate was 3%, and the fund's volatility was 10%:
| Input | Value |
|---|---|
| Annual return | 8% |
| Risk-free rate | 3% |
| Excess return | 8 − 3 = 5% |
| Volatility | 10% |
| Sharpe ratio | 5 ÷ 10 = 0.5 |
A higher Sharpe ratio means more excess return for each unit of volatility. It is most useful for comparing funds over the same period. Its main weakness is that it treats volatility as the whole of risk, which, as we'll see, it isn't.
Maximum drawdown
A drawdown is a fall in NAV from a previous peak. Maximum drawdown is the largest such fall over a period, from peak to the lowest point (the trough) before a new peak:
Maximum drawdown = (peak − trough) ÷ peak
Here is an illustrative path for Kessling Harbor's NAV per share:
| Point | NAV per share |
|---|---|
| Start | $100 |
| Peak | $120 |
| Trough | $90 |
| Latest | $115 |
The fall from $120 to $90 is $30, so the maximum drawdown is 30 ÷ 120 = 25%. At $115, the fund is still below its peak, and it has not yet made a new high.
Drawdown matters because losses are harder to recover than they look. To get from $90 back to $120, the fund needs to gain 30 ÷ 90 = 33.3%, more than the 25% it lost. Drawdown also speaks to how investors experience risk: a large fall can trigger redemptions, and fund investors rarely all have the patience to wait for a recovery. Allocators often look at how long a drawdown lasted and how long recovery took, not just its depth.
Correlation, beta and alpha
Many investors hold hedge funds to add something different from their stocks and bonds. Three measures help test that.
- Correlation measures how closely the fund's returns move with a market, on a scale from −1 to +1. Near +1, they move together; near 0, there's little relationship; negative, they tend to move in opposite directions.
- Beta measures how much the fund tends to move for a given market move. A beta of 0.5 means that, on average, when the market falls 10%, the fund tends to fall about 5% from its market exposure. An equity long/short fund's net exposure (lesson 2.1) gives a rough first idea: Kessling Harbor's +40% net exposure suggests a beta well below 1, though the actual beta depends on which stocks it holds.
- Alpha is the part of the return not explained by market exposure: the value, in principle, of the manager's own decisions, such as good stock picks on both the long and short side.
Beta returns are cheap to obtain; an investor can buy market exposure through low-cost funds. Alpha is what investors pay hedge fund fees for. So an allocator will ask how much of a fund's return is beta dressed up as alpha. A fund that returned 8% during a strong stock market, with a high beta, may have added little of its own. Estimates of alpha depend on the market measure and the period used, so treat them as estimates, not facts.
When the numbers mislead
Hedge fund figures are only as good as the data behind them. Several common problems can make a fund look better than its risks:
- Short track records. A fund with two or three years of history may never have been through a difficult market. Its Sharpe ratio and drawdown describe the conditions it happened to meet, not the ones it could meet.
- Survivorship bias. Commercial hedge fund databases rely largely on funds choosing to report. Funds that do badly often stop reporting or close, and may drop out of the data. The funds left behind look better on average than the full group really did.
- Smoothed returns. Funds holding hard-to-value assets, such as distressed debt or private stakes, price them with models or infrequent quotes. Model prices tend to move gradually and lag the market, as PC101 4.2 explains for private loans. Reported volatility and correlation look lower than the true risk, which flatters the Sharpe ratio.
- Rare large losses. Some strategies earn small, steady gains most of the time and occasionally suffer a large loss. Merger arbitrage (lesson 2.3) is the classic example: a position might earn the 8.7% spread when deals close, but lose 21.7% if a deal breaks. A record with no broken deals can show low volatility and a high Sharpe ratio right up until the loss arrives.
This is why allocators read the figures together with the strategy. Ask what could cause a large loss, whether the track record includes a stressful period, and how the assets are valued.
Key terms
- Net return: the change in NAV per share after fees and expenses.
- Compounding: combining returns by multiplying growth factors, not adding percentages.
- Volatility: the standard deviation of returns; a measure of how much they vary.
- Risk-free rate: the return available with almost no risk, such as on short-term government bills.
- Sharpe ratio: (return − risk-free rate) ÷ volatility; excess return per unit of volatility.
- Maximum drawdown: the largest percentage fall from a peak to a subsequent trough.
- Correlation: how closely two sets of returns move together, from −1 to +1.
- Beta: how much a fund tends to move for a given move in a market.
- Alpha: return not explained by market exposure.
- Survivorship bias: the flattering effect of leaving closed or non-reporting funds out of a data set.
Key takeaways
- Returns are usually monthly and net of fees, and they compound: +20% then −20% leaves you down 4%.
- The Sharpe ratio is excess return per unit of volatility: (8 − 3) ÷ 10 = 0.5 in the Kessling Harbor example.
- Maximum drawdown shows the worst peak-to-trough fall: $120 to $90 is 25%, and recovery needs a 33.3% gain.
- Beta measures market exposure; alpha is what's left, and it's what investors pay hedge fund fees for.
- Short track records, survivorship bias, smoothed prices and rare large losses can all make figures look safer than the risk.
This lesson is for educational purposes only and is not investment advice.