Hedge funds are usually compared to the S&P 500 (INDEXSP:.INX) or some other stock index as a way of deciding whether the fund is underperforming, but this approach suggests that investors have to decide between the two when they usually play different roles in a portfolio. This approach makes sense when comparing different asset classes (eg the spread between stocks and bonds) when deciding how a portfolio should be weighted, but even this breaks down when choosing hedge funds.

“Hedge funds are not an asset class. They are a way of managing money that typically features managers who have more tools at their disposal, more freedom of manoeuvre, and more specialised strategies,” says a recent Alternative Investment Management Association (AIMA) research paper, Apples and Apples: How to better understand hedge fund performance. The paper argues that hedge funds have to be analyzed along a number of different axes before investors responsibly can decide where to put their money.

Risk-adjusted returns is always key

The place to start is with risk-adjusted returns. Over a full business cycle, hedge funds tend outperform stocks in annualized ‘headline’ returns, but not necessarily enough to account for the fees that come along with it. But when volatility is taken into account, the performance gap between equities and hedge funds widens, and institutional investor allocations to hedge funds make a lot more sense.

annualized return Hedge Fund comp 0414

But even this washes out a lot of important details. Just because a long/short fund is outperforming doesn’t mean that a fixed income fund will be, and a ‘tail risk’ fund will most likely be underperforming, pulling the net return closer to zero when you look at hedge funds as a whole. Deciding which strategies meet your investment needs and then comparing long-term data within a specific strategy gives a better sense of who is outperforming their peers.

Hedge funds need to be compared to appropriate benchmarks

Similarly, you want to choose a benchmark that makes sense for the hedge fund strategy you are investing in. For long only equity funds, that might be the S&P 500 (INDEXSP:.INX), but that doesn’t make sense for a distressed debt or fixed income fund. Distressed debt might not meet your investment needs, but if you decide that it does there’s no point expecting it to track the stock market.

Hedge Fund  vs underlyign assets 0414

Hedge fund indices can also give a sense of how the industry as a whole is performing, but it runs into similar problems when you compare a specific fund against an index. Depending on how they are constructed the spread in returns between indexes can hit double digits in just a few years, so one might give you the impression that your fund is an all-star while the other tempts you to pull your money out. It’s important to know what indexes are actually based on before basing any decisions on them.

dispersion of Hedge Fund index performance 0414