Core Performance Metrics
The mathematical lens through which we evaluate risk-adjusted returns.
Sharpe Ratio
The industry standard for risk-adjusted return. It measures excess return per unit of total risk (volatility). A higher ratio indicates better historical risk-adjusted performance.
Sortino Ratio
Similar to Sharpe, but only penalizes downside volatility. This is crucial for hedge funds, as upside volatility (unexpected high gains) is generally desirable.
Alpha (α)
The measure of active return on an investment. It gauges the performance of an investment against a market index or benchmark which is considered to represent the market's movement as a whole.
Beta (β)
A measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. A beta of 1.5 implies the asset is 50% more volatile than the market.
Maximum Drawdown
The maximum observed loss from a peak of a portfolio, before a new peak is attained. It is a key indicator of downside risk over a specified time period.
Information Ratio
Measures portfolio returns beyond the returns of a benchmark, compared to the volatility of those returns. Ideally, you want a high excess return with low tracking error.
Accounting for Cash Flows
Timing matters. How we handle deposits and withdrawals drastically changes the performance picture.
Time-Weighted Return (TWR)
Calculates the compound rate of growth over a period. It eliminates the distorting effects of cash inflows and outflows.
Money-Weighted Return (MWR)
Essentially the Internal Rate of Return (IRR). It accounts for the size and timing of cash flows, reflecting the actual experience of the investor.
The "Cash Drag" Dilemma
In hedge funds, managing cash flow is critical. A large inflow of cash (subscription) creates "cash drag"—diluting performance until deployed. Managers often use Subscription Lines or Equalization methods to ensure new investors don't dilute existing returns or inherit unrealized gains unfairly.
Benchmark Selection
You can't hit a target you haven't defined. Picking the right yardstick is an art form.
Strategy Alignment
Often benchmarked against broad equity indices like the S&P 500 or MSCI World, sometimes with a beta-adjustment (e.g., 50% S&P 500).
Hard to benchmark due to flexibility. Often uses an "Absolute Return" hurdle (e.g., Cash + 5%) or a composite of global bonds/equities.
Benchmarked against High Yield indices or specific Distressed Debt peer group indices.
The "SAMURAI" Check
A good benchmark must adhere to strict properties to be valid.
Specified in Advance
The benchmark cannot be cherry-picked after seeing the results.
Appropriate
It must reflect the manager's investment style and geographic focus.
Measurable
Its value can be determined on a frequent basis.
Unambiguous
The identities and weights of securities are clearly defined.
Investable
It represents an alternative the investor could actually purchase (e.g., an ETF).