So, when an investor is considering a particular hedge fund,
they want to know, what are the goals for the hedge fund?
And they'll also want to know the results of certain metrics.
Let's take a look at goals first.
Now, you might say, of course, my goal is to make money.
Well, it's a little bit finer than that, or a little bit more subtle than that.
There are, of course, other potential goals, but
these two are the primary types of goals that hedge funds go after.
One type is to beat a benchmark.
What does that mean?
Let's suppose, for instance, that you've got a strategy that looks at the stocks
that are in the S&P 500, there's 500 of them of course and
you're especially smart at picking out the good ones.
So you might build a hedge fund who's goal is to beat the S&P
500 index as a benchmark because you're wise at selecting
among all those, which stocks are going to outperform?
And, of course, the over all index has the good stocks and the bad stocks,
so you're going to do better because you picked the specific good ones.
An important component of the benchmark model is
that many benchmarks, like the stock market as a whole, for
which S&P 500 is a good representative, go down.
And it is of course natural that a portfolio consisted of
stocks from this index might go down as well.
So, even though both the index and the fund go down,
you can outperform the index by going down less.
So, this kind of fund that is tagged against a benchmark
can still meet performance goals if it goes down.
So long as that index is going down more.
That brings us to absolute return funds.
Their goal is to provide positive return no matter what.
These funds are usually long/short,
which means they make positive bets in stocks they think are going to go up.
And they make negative bets in stocks are going to go down.
We'll talk about shorting a little bit later.
In any case there objective is to make
slow gradual positive return no matter what.
Often, these types of funds don't make the same percentage gains
as the beat a benchmark fund, but they have very low draw downs.
In other words, when the market takes a bit hit, they often don't.
The next question is well,
how do we measure how well that fund is meeting those goals?
We talked about these metrics in the mini course
manipulating financial data in Python, but
we'll repeat it just a little bit here to remind you, and also to bring those
folks up to speed who didn't necessarily have the previous course.
Cumulative return is a measure of, given the funds I started with,
how much more did I end up with after a certain amount of time?
So suppose we have and in the array of values of our portfolio,
where zero is the first value, and minus one is the very last one.
We can easily compute cumulative return by dividing that last value
by the first value and subtracting one.
So for instance if we made 20% over a year this would end up being 0.2.
Volatility is a measure of how rapidly and aggressively the portfolio
goes up and down in value and of course lower volatility is better.
Volatility is simply measured as the standard deviation of daily returns.
Our last factor here which is a measure of the ratio of risk to reward is
typically measure using sharp ratio, and the sharp ratio is calculated like this.
Sharp ratio is also sometimes called risk adjusted reward.
So, you can consider that to be reward divided by risk.
A reward is our average, daily return minus the risk-free rate.
And our risk is simply a measure of that standard deviation of daily returns or
volatility.
We multiply that ratio by the square root of 252.
That is how many trading days there are in a year and
remember we're always working with daily returns.
So that's why we use this 252 number.
So recapping, hedge funds have goals,
typically either to meet a particular bench mark or to gain absolute return.
And then metrics by which we judge how well they accomplish those goals.
So, cumulative return, how much do they make over a period of time?
Volatility, how volatile were they over that time?
And then risk adjusted reward or sharp ratio.
One thing I want to mention before I leave this topic with regard to
benchmarks is the benchmark you choose should depend on the expertise you have.
So let's suppose you're an expert in Eastern Europe.
And you're great at picking stocks in emerging markets in Eastern Europe.
You should select some benchmark that represents
that similar kind of investing.
And there are indexes that represent emerging markets in eastern Europe.
There are also other funds who's values you might use as a benchmark or
let's say your expertise is in banks.
You might choose an index for the banking industry and
show that you can beat that.