Performance and Evidence · Hedge Funds

Risk adjusted statistics compress a return history into a few numbers. They help comparison only when their inputs, limitations and economic meaning are understood.

Read the ratio’s ingredients

A Sharpe ratio relates average excess return to return volatility. The cash benchmark, sampling frequency, annualization method and observation period matter. Use consistent conventions when comparing funds. A high ratio calculated from a short or smoothed record deserves additional scrutiny.

If annual excess return is 6% and annual volatility is 8%, a simplified ratio is 0.75. This calculation does not say that losses are capped at 8%, nor does it describe the size of an extreme negative month. Volatility measures dispersion, not every kind of risk.

Look at the shape of losses

Downside measures focus on returns below a selected threshold, while drawdowns measure declines from previous peaks. Their results depend on the threshold, frequency and sample. A strategy collecting small recurring gains can look attractive until a rare large loss occurs.

Illiquid positions may be revalued infrequently or using estimates that adjust slowly. This can reduce measured volatility and correlation without reducing economic exposure. Compare the valuation process with the apparent smoothness before concluding that the fund is an unusually stable diversifier.

Correlation is conditional evidence

Correlation summarizes how two series moved together over the chosen sample. It does not explain why they moved, and it can change during stress. A fund that is weakly correlated with stocks in calm periods may still lose alongside them when financing tightens.

Review rolling periods, stress episodes and underlying exposures. Compare both return correlation and cash demands. Two funds with different return patterns can still require liquidity at the same time. Statistical diversification and operational resilience should be assessed together.

Try it yourself

Fund A has 4% excess return and 4% volatility. Fund B has 6% excess return and 8% volatility. Which has the higher simplified Sharpe ratio, and is that enough to choose it?

Show the worked answer

A has 1.0 versus B’s 0.75. That is not enough to choose A. Valuation quality, tail risk, costs, liquidity, sample length and portfolio fit still matter.

Further reading

Educational material, not a recommendation to buy or sell a fund. Numerical examples are hypothetical. Fund terms, investor eligibility and tax treatment vary by product, account and jurisdiction.

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