The ultimate goal of an investment is to make a profit. To succeed with a hedge fund investment, investors need to modify their investment models, analyze their target funds, and make money. Hedge fund investment aims to generate profits or returns through intelligence investments. That is why measuring their performance is an essential concept. Using key performance metrics to analyze hedge funds helps spot areas that need improvement and increase returns over time. Hedge fund advisory firms know how to measure hedge fund performance to earn the most profit from the investment.
Several performance metrics are crucial to help measure a fund’s success. We will talk about a few of them here.
Beta (β): It is an asset’s measure in relation to the market risk. It largely depends on the investor’s risk tolerance and preference. If they can comfortably take a higher risk level, they may build a portfolio with a beta of over 1.3. An investor may obtain the desired beta measure by investing in various market products with equal weight to safer and riskier investment options.
Alpha(α): It is the difference between a portfolio’s or asset’s return and its benchmark’s return in relation to beta, the risk taken. Simply put, alpha is the excess return an asset gains above the market’s return. Alpha provides context and accounts for risk, enabling the investors to compare their returns with the market returns directly.
Sharpe Ratio: Sharpe ratio is the percentage of return gained per risk unit. It helps compare two assets’ performances with different risk levels. Similar to alpha, it measures an asset’s performance compared to risk. However, instead of comparing it with the market, it compares several assets with each other.
Information Ratio: Information ratio refers to an asset’s excess return divided by its tracking error. It is a standard deviation measured by calculating a hedge fund’s alpha or excess returns. Although it measures return per risk unit similar to the Sharpe ratio, it focuses more on excess than total returns. Hedge fund advisory firms use information ratios to tell if an investor should take the risk of outperforming the market. If the ratio is high, the strategies have a high chance of paying off.
Gross IRR: IRR, or internal rate of return, is a critical metric that helps predict an investment’s profitability. It indicates a hedge fund’s expected growth rate, especially its annual growth rate. It allows companies and investors to analyze returns and foresee annual profits with varying project courses.
Invested Amount: As its name suggests, the invested amount refers to an investor’s money in a particular hedge fund. Although it cannot predict a fund’s profitability over time, it helps compare with other metrics like IRR and ROI.
Multiple: MOIC or Multiple of Invested Capital, known as ‘multiple’, is a critical metric that indicates how much money an investor will get from the investment. Since multiple does not consider time during measurement, comparing it with other metrics is crucial.
ROI: One of the most crucial hedge fund metrics, ROI means ‘Return on Investment’. It indicates an investment’s profitability and compares it with the investment cost. Expressed as a ratio or percentage, ROI in a positive percentage indicates profitability while a negative percentage indicates a loss.
Total Cash Realization: Many hedge fund advisory firms predict ROIs based on different metrics without actually receiving those returns. Each metric has a system to measure the ROI. However, it’s crucial to remember that any metric predicting future gains are unrealized. Total cash realization is the amount of profits investors receive in return for their cash.
Fair Value: Fair value refers to the estimated value of a hedge fund or an approximate amount a hedge fund may sell for. For instance, discounted cash flow is a formula to calculate a fund’s fair value. In this evaluation system, the investment’s value is the total value of the fund’s future cash flow at current rates. In other words, a fund’s valuation indicates the cash an investor may distribute when they sell the fund.
Investors have multiple hedge fund performance metrics that hedge fund advisory firms will find helpful in assessing a fund’s profitability. Those interested in hedge fund investments can build a sound foundation on which to base their knowledge. However, remember each metric aims at comparing an asset to its benchmark while weighing the risk involved.