Per Connor et al (2005), many of the portfolio managers are more concerned with active risk management. Active risk management is the management of active returns, which is total return minus benchmark return. However, the investors are concerned with both total risk management as well as active risk management, to keep a tab on both the whole risk of their investment as well as to know whether the portfolio manager has properly allocated funds and positioned his stocks across benchmarks.
For hedge funds, there is no variance between total risk and active risk as the benchmark return is free from risk.Variance-based approach and value-at-risk approach are two risk approaches which are generally used by fund managers to measure portfolio risk. Variance based approach use the statistically calculated factor, Variance, to measure the risk of the portfolio.
Variance is the expected squared deviation of the return from its mean. If the portfolio return is normally distributed, then the variance of the return fully represents the riskiness of the return. If the returns are very different from the normal distribution, then this approach may not be very useful. Thus this approach does not work well for derivative funds or portfolios with derivatives since they lack normality. Since most of the hedged funds contain derivatives (except certain plain vanilla futures), this approach may not be very useful for hedge funds.Another approach called Value-at-Risk (VaR) was proposed for risk measurement to monitor hedge fund risk and protect against extreme events.
It is described as the maximum loss that would require to be borne for a given time period at a given level of probability (Connor et al, 2003). The strength of VaR lies in it its general nature. It works for non-linear models and portfolios containing derivatives.The disadvantage in this kind of approach is that it is difficult to estimate the true probability of events with low probability. More comprehensive methods like Stress testing to explore the source and measure the severity of events with low probability have been prescribed as additional hedge funds assessment techniques. Stress tests are computerised tests that examine what-if simulations of a portfolio’s reactions to extremely adverse market conditions.
They measure impact of simultaneous adverse changes on prices, bond yields, forex rates, volatility and correlations on portfolio value. Adrian (2007) also prefers measuring risk based on cross-sectional dispersion of returns, which is termed to be the volatility of the returns across funds at each point of time. It uses indicators such as volatility, correlation and covariance.PERFORMANCE MEASUREMENTDue to the massive expansion in the hedge fund industry, there is a requirement to develop benchmarks against which performance of a particular hedge fund can be compared with.
The other need of benchmarks arise when performance of hedge funds have to be compared with other classes of assets. This has given rise to the development of hedge fund indices which are currently calculated by third parties such as Credit-Suisse, Greenwich, Hedge Fund Research, etc (Connor et al, 2005).The most frequently used is the HFRI Equity Hedge Index (Blackstone, 2013). Though these are frequently used, they suffer from limitations like survivorship bias (ie. The index may not be representative of returns from all funds since the low-performing ones tend to leave the index), heterogeneity (ie not all funds are comparable or alike) and limited data and selection bias (ie many hedge funds fail to report to indices, thus skewing the picture due to their significant impact, if any), etc.
Sharpe Ratio is a generally used statistical tool that measures risk-adjusted performance. It is the return from the portfolio above the risk-free rate, which is adjusted for risk. Annualised Standard Deviation helps in estimating this risk. Higher the Sharpe ratio better is the performance. Khanniche (2008) states that hedge funds look very attractive as estimated by means-variance approach since their average means are greater than those of stocks and bonds. Their average standard deviations are lower than those of indexes of stock markets and their Sharpe Ratios are good. However, when their skewness and kurtosis coefficients are calculated, it is found that both these are substantial in the hedge funds return distribution.
Thus the performance distribution of these strategies is far from being normal. Thus the research finds that volatility cannot be considered as a relevant measure of hedge funds risk and hence Sharpe ratio cannot be considered for measuring performance, since it has a tendency to overestimate it. She finds that instead of Sharpe Ratio, performance measurement by using Downside Risk and Sortino ratio would prove helpful.Downside Risk indicator takes into account asymmetric risk and concentrates only those returns that are below are certain threshold as acceptable.
By replacing volatility by downside risk in Sharpe ratio, we derive the Sortino ratio. It is the return which the portfolio generates above the threshold performance, adjusted for risk, measured by downside risk. The other performance measurement models include the Capital Asset Pricing model (CAPM), multi-factor models, Carhart’s model, etc as discussed by Capocci et al(2004)1. CONCLUSIONThe introduction of hedge funds has made the investment markets more exciting, innovative and competitive. It has resulted in exploring and exploiting a lot of talented managers who have been compensated with lucrative packages and heavy capital inflows.
Over the last 20 years, the market risk (Beta) of HFRI Equity Hedge Index to the S&P 500 has been approximately 0.45, signifying that it normally moves around half of that of the broad market. This gives elasticity to the managers to take advantage of more efficient exposure to equities. Thus, for long-short managers, the challenge is to determine the optimal level of market participation, through using tools such as Shorts, leverage etc. to overcome the volatile trends in equity pricing (Blackstone, 2013).Given the helpful environment for stock-pickers, the forecast for the performance of Long-Short Equity strategies in the hedge fund industry has been positive (Durden, 2014). This view is also supported by Neuberger Berman Report (2014) which provides a positive strategic outlook for long-short equity hedge trading strategies. They say that lower stock correlations and greater valuation spread will enable such strategies to generate more “alpha”.
It further states that in case there is market pull-down, a fine short position of this kind of strategy would ideally help in minimizing the downside impact of the market conditions.