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Hedge Fund Risk Measurement

Hedge Funds

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Hedge funds can create a large variety of risks for their investors which vary with their target market and trading strategies. Hedging reduces losses incurred below certain investment levels, while hopefully maintaining decent levels of investment performance. Funds with skilled managers will reduce or eliminate risks using hedging techniques, which is where the name hedge fund arises. Funds can use options, futures, custom derivatives, or investments with opposing correlations to achieve this goal. Options will secure a sale or purchase price when investment market values reach a specific level. Futures will secure a price for an investment in the future. Instruments with opposing correlation will move upward the price of opposing investments move downwards in an unequal fashion, and vice-versa.

As a potential hedge fund investor, your primary goal is to seek risk adjusted returns. Returns which do take risk into account are worthless, since you are not aware if the hedge fund manager simply incurred higher risk to create higher returns or generated more returns from a level of risk than other managers can accomplish. The first of these two options is natural and requires no particular skill by the manager, the latter of these two options is a representation of managerial talent called “skill alpha”. Alpha compares the volatility of a fund against an index, while simultaneously comparing its return to the same index. Acquiring higher alpha is among your primary objectives as a hedge fund investor.

Ask for a report of the fund’s assets, liabilities, derivatives, and positions the fund holds solely for the purpose of estimating their risk level. Very few funds will deliver this information, and most will only do so if you’re heavily invested in the fund, have signed a confidentiality agreement, and have been a long term client. If given, this will assist you in deciphering the risk level of the fund as well as the degree that it meets your portfolio’s specific needs. The positions will be modified by leverage, and may not indicate the firms actual risk level.

Funds may report risk outright using several indicators, including alpha. The risk level might not be accurate; since firms can manipulate several factors displayed for investors in risk and return reports. Firms may be tempted to modify indicators that affect risk levels prior to audits and financial calculations by unwinding or modifying positions and assets held, and then resuming business as normal. This gives the appearance of higher profit derived from lower risk, instead of showing the higher risk levels generating higher profit, and thus the false appearance of alpha (or other risk indicators).

There are several biases which appear in hedge fund risk reporting. If you are researching hedge funds, you may find there is simply years “missing” of open or public reports. This is fairly common among poorly performing hedge funds. There are no regulations forcing open display of returns. Funds that have poor earnings do not have to publicly display their returns and choose not to do so to hide their flaws. Funds may choose not to disclose returns for other reasons, but normally hide due to poor performance or closure. If a fund is closing the last return is rarely reported publicly.

There are many principal measurements of risk, which are comparable across hedge funds. These consist of the following: Standard Deviation, Beta, Jensen’s Measure, Sharpe Measure, Treynor Ratio, Appraisal Ratio, and Value at Risk. Each ratio interprets risks differently, and you should review as many as possible.

Hedge Fund Risk Measurement: Standard Deviation

Standard deviation is simply how far returns stray from a mean. A higher amount of standard deviation indicates more volatility and wider fluctuations in price. Certain funds actively trade with the objective of limiting standard deviation. Other funds trade purely for return, ignoring standard deviation entirely.

Hedge Fund Risk Measurement: Beta

A fund’s beta is the distance that the fund moves in relation to market movements. If the market moves upward a set percentage, and the fund’s value moves upwards equally, the beta is 1. If the fund moves twice the percentage, the beta is 2. If it moves less than the market’s movement, the beta is below one. A beta which moves inverse to the market is negative. Beta measures volatility in relation to the market.

Hedge Fund Risk Measurement: Jensen’s Measure

Jensen’s Measure compares an asset’s average return to a prediction of its expected return. The measure is also known as Jensen’s Alpha or Jensen’s Performance Index. The prediction is derived from the Capital Asset Pricing Model, shortened to CAPM. The equation for CAPM follows, note you need the hedge fund’s beta, the risk free rate typically acquired from government bonds, and the market rate.

The equation for Jensen’s Measure follows. The CAPM model calculates the variable labeled “Expected Total Portfolio Return” in Jensen’s Measure.

A positive result indicates a higher than expected return for the level of risk taken by a manager. This indicates strong performance by the manager. A negative result indicates poor performance, since the manager has generated poor return for the level of risk taken. If the equation is zero, the manager’s skill is neutral. They have generated an adequate return in relation to risk.

Hedge Fund Risk Measurement: Sharpe Ratio

The Sharpe Ratio relates returns and the risk level. A higher number indicates returns came from smart investment selections rather than risks. A lower number indicates returns came from risks. A higher number is always preferable. The formula for the Sharpe Ratio is below:

Hedge Fund Risk Measurement: Appraisal Ratio

The Appraisal Ratio compares the alpha of an asset or basket of assets to the basket specific risk of the portfolio. Managers should acquire return beyond expected for a specific risk level. Their ability to perform will result in positive alpha. The appraisal ratio isolates alpha from the systematic risk found in the market. The appraisal ratio follows:

By isolating alpha from the systematic risk of the market, investors can get a better look at the alpha generated purely by the fund manager’s skill. Only the manager’s asset selections are generating the fund’s alpha, since the market risk is removed by the equation. Higher appraisal ratios indicate better fund performance.

Hedge Fund Risk Measurement: Value at Risk

Value at Risk, or VAR, indicates the risk of losing a specific amount of money over a specific amount of time. The figure will state the potential loss, chances of incurring that loss, and the time frame the numbers are valid. These numbers are not static, and you should assume if market conditions change substantially VAR will as well. Value at Risk is quoted with a margin of error to compensate for a potential change. This indicator will normally be provided by the fund, since it is extremely difficult to calculate manually.

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