Use of Market Indices to evaluate Hedge Fund Performance

Broad Market Indices.

Individual investors tend to view hedge fund performance in absolute terms. In other words, did the fund provide a positive return or not, regardless of how the market did? In contrast, individual investors view performance in relative terms: did the hedge fund outperform the market?

The problem in the latter case is that it is a difficult to determine what benchmark index should be used to proxy for the market Hedge funds themselves do not help in this matter because their portfolios experience high turnover and are not transparent. As a result, investors often use a broad-based market index such as the Russell 3000 to measure performance, even though that may be inappropriate.

Both the Sharpe ratio and Jensens alpha are used to measure hedge fund performance. There are problems using these measures to asses hedge fund performance. First, they require the use of a market portfolio benchmark. According to Joe Healy Hedge Fund the S&P 500, which has been used for long-only funds, is not appropriate for hedge funds. Second, a hedge funds beta will be quite volatile over time as the fund manager adapts to changing market conditions or changes the funds risk exposures. Third, Alpha can vary as the periodicity if the return interval changes (e.g. a monthly alpha will differ from a 5-year alpha). Alpha tends to deteriorate over time, with older funds alphas being lower then newer fund alphas.

The strategies for the fixed income hedge fund are differentiated by CSFB/Tremont as being fixed income arbitrage, distressed securities, or convertible arbitrage. When they are compared against Lehman Bond Index, The Merrill Lynch High Yield Index, The S&P 500, and the Russell 3000, all three fixed income strategies have the highest correlation with the yield index. This suggests that the best market index to use for a fixed income hedge fund is the high yield index.

Equity Hedge funds can be differentiated as long/short equity, equity market neutral, global macro, or emerging markets. The Russell 3000 explains the returns of long/short equity and emerging markets funds the best, but it does about the same as the S&P 500 at the explaining the returns of equity market neutral and global macro funds.

In sum, the Merrill Lynch High Yield index may be the best market index for fixed income hedge funds, and the Russell 3000 may be the best market index for equity hedge funds. However, a combination of indexes may be the best market index through the use of multi-factor models. Multifactor models to the best in explaining mutual fund returns, which suggests that they might also be useful in explaining hedge fund returns