Measuring the Volatility of Hedge Fund Returns

Abstract

Noting that a common question circulating among academics and investors alike is how to measure risk, the author notes that there has yet to be a single quantitative measure that can properly encompass the risks inherent in hedge funds. Quantitative factors are often mistakenly cited as the “risk” of a strategy, when they are in fact only one component of a hedge fund manager's risk. There are over a dozen known calculations to analyze risk, but the author suggests that they are primarily based on two basic measures. In the traditional framework, volatility measures focus on application of the standard deviation of returns, whereas hedge fund practitioners tend to emphasize the drawdown calculation. The latter measure has evolved in an attempt to provide non-traditional or hedge fund investors with more insight into potential risks they may encounter in the future. The author then will compare the results of ratios applied to traditional and hedge fund portfolios so that the reader can gain a perspective as to the magnitude of these challenges.