Core Calculation Methodologies
The foundation is choosing the correct return calculation method based on fund structure and liquidity.
Time-Weighted Return (TWR)
The standard for measuring manager skill in liquid markets (e.g., public equities). Neutralizes the distorting effects of external client cash flows.
Money-Weighted Return (IRR)
Required metric for illiquid, closed-end funds (e.g., private equity). Manager controls capital timing, making timing part of performance assessment.
Modified Dietz
An approximation for TWR used when daily valuation isn't feasible. Weights cash flows by time remaining in period.
Calculation Method Selection Framework
Liquid Strategies
Long/Short Equity, Market Neutral, Arbitrage
Illiquid Strategies
Private Equity, Distressed Debt, Real Estate
Mixed Liquidity
Multi-Strategy, Credit Opportunities
Risk-Adjusted Performance Metrics
Returns must be evaluated relative to the risk taken. Raw returns without risk context are meaningless.
Sharpe Ratio
The universal standard measuring excess return per unit of total volatility. Limited by assumptions of normal return distributions. Values above 1.0 are considered good, above 2.0 excellent.
Sortino Ratio
Improves on Sharpe by focusing only on downside volatility. More appropriate for hedge funds as upside volatility is desirable. Better reflects investor risk perception.
Information Ratio
The key metric for active managers. Measures excess return relative to benchmark per unit of active risk. Values above 0.5 indicate skill, above 1.0 exceptional skill.
Calmar Ratio
Critical for evaluating leveraged strategies. Measures return per unit of worst-case loss. Particularly important for CTA and macro strategies with high volatility.
Sterling Ratio
Similar to Calmar but uses average of largest drawdowns over time. Provides more stable measure for strategies with multiple significant drawdowns.
Omega Ratio
Considers entire return distribution, not just first two moments. Captures skewness and kurtosis effects crucial for option-heavy strategies and tail risk assessment.
Drawdown Analysis Framework
Key Drawdown Metrics
Worst single loss period. Critical for risk budgeting and leverage decisions.
Typical loss magnitude. Better for strategies with frequent small drawdowns.
How long to recover from drawdowns. Critical for investor psychology.
Drawdown Severity Classification
Note: Acceptable drawdown levels vary by strategy. Market neutral funds should stay under 5%, while global macro funds may accept 15-20%.
Cash Flow Impact Analysis
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 by breaking the measurement period into sub-periods.
Money-Weighted Return (MWR)
Essentially the Internal Rate of Return (IRR). It accounts for the size and timing of cash flows, reflecting the actual wealth generation 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.
New investors pay for unrealized gains
Separate share classes by entry date
Public Market Equivalents (PME) for Private Funds
Kaplan-Schoar PME
Creates apples-to-apples comparison with public markets by investing contributions in a public index and comparing terminal values.
Direct Alpha Method
Directly calculates the alpha by comparing IRRs of the private fund versus a public market equivalent with identical cash flow timing.
Attribution Analysis
Decomposing returns to identify the true source of value creation and distinguish skill from luck.
Brinson Model
Used for long-only equity portfolios. Breaks excess return into three components to identify where value is being added or destroyed.
Allocation Effect
Value from over/underweighting sectors relative to benchmark
Selection Effect
Value from picking better stocks within each sector
Interaction Effect
Combined effect of allocation and selection decisions
Factor Attribution Models
Essential for hedge funds. Uses regression to determine how much return comes from systematic risk factors versus true manager skill ("alpha").
Fama-French Model
Market, Size, and Value factors for equity strategies
Fung-Hsieh Model
Includes trend-following and option-like factors for hedge funds
Alpha Interpretation
α > 0: Manager adds value beyond systematic factors
α ≈ 0: Returns explained by factor exposures
α < 0: Manager destroys value after fees
Factor Model Selection by Strategy
Equity Long/Short
- • Market Beta (S&P 500)
- • Size Factor (SMB)
- • Value Factor (HML)
- • Momentum Factor
- • Quality Factor
Global Macro
- • Currency Carry
- • Bond Trend Following
- • Commodity Momentum
- • Volatility Risk Premium
- • Term Structure
Credit Strategies
- • Credit Spread Changes
- • Default Risk Premium
- • Term Structure
- • Equity Market Beta
- • Liquidity Factor
Advanced Risk Management
Forward-looking risk assessment complements historical performance analysis for comprehensive evaluation.
Value at Risk (VaR)
Estimates potential loss over a set period at a given confidence level. Standard risk measure but limited by distributional assumptions.
Conditional VaR (CVaR)
Superior measure that calculates average loss in worst-case tail beyond VaR threshold. Captures extreme "tail risk" better than VaR.
Why CVaR is Superior
Risk Measurement Methodologies
Parametric Method
Assumes normal distribution. Fast computation but poor for fat-tailed returns common in hedge funds.
Historical Simulation
Uses actual historical returns. No distributional assumptions but limited by historical data availability.
Monte Carlo
Simulates thousands of scenarios. Most flexible but computationally intensive and model-dependent.
Stress Testing Framework
Historical Stress Tests
Hypothetical Scenarios
Benchmark Selection
Selecting an appropriate, investable benchmark is crucial for fair comparison. Benchmarks must meet strict criteria.
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 for performance comparison.
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.
Reflective
It should reflect current investment opportunities available to the manager.
Accountable
The manager should accept the benchmark as a fair measure of their performance.
Investable
It represents an alternative the investor could actually purchase (e.g., an ETF).
Reporting & Communication
Effective synthesis and presentation are the final steps in performance evaluation. GIPS compliance ensures fair representation.
GIPS Standards
Global Investment Performance Standards ensure fair representation and comparability across managers and time periods.
Composite Construction
All fee-paying, discretionary portfolios managed according to the same strategy must be included.
Performance Calculation
Must use time-weighted returns for periods of one year or longer, with monthly valuations minimum.
Disclosure Requirements
Must disclose fee structure, benchmark, number of portfolios, and any material changes to strategy.
Essential Reporting Tools
Professional reports combine metrics, attribution, and risk analysis using intuitive visualizations.
Growth Charts
Show cumulative performance vs benchmark over time. Essential for visualizing long-term value creation.
Underwater Charts
Display drawdown periods and recovery times. Critical for understanding risk profile and investor experience.
Rolling Window Analysis
Shows performance consistency across different time periods. Reveals strategy robustness and regime dependence.
Professional Reporting Framework
Performance Summary
- • Total Return (Net/Gross)
- • Benchmark Comparison
- • Risk-Adjusted Metrics
- • Volatility Analysis
Attribution Analysis
- • Factor Exposures
- • Alpha Decomposition
- • Sector/Security Attribution
- • Style Analysis
Risk Assessment
- • VaR/CVaR Analysis
- • Stress Test Results
- • Correlation Analysis
- • Tail Risk Metrics
Market Context
- • Market Environment
- • Peer Comparison
- • Strategy Commentary
- • Outlook Discussion