In evaluating a hedge fund, historical returns are the most solid data investors have. Historical returns, however, are useful only to whatever extent they have predictive value, and that's a judgment investors must make based on a range of qualitative factors. Qualitative judgments relating to investment strategy and operations are often of greater importance than historical returns. But investors still need to analyze historical returns in the most insightful way.
Analyzing a hedge fund's historical returns
The correlation of a hedge fund with the stock market is what determines the fund's diversification benefit for an institutional portfolio, because the overwhelming risk for virtually every institutional portfolio is stock market risk. True diversification, defined as low correlations among portfolio investments, allows us to invest in higher-volatility, higher-return assets without materially increasing overall portfolio volatility.
Hedge funds might be grouped under two main categories:
- Substitutes for equities — hedge funds with equity-like returns but lower volatility and higher correlations to equities.
- Hedge funds with correlations to equities of 0.3 or lower, which provide much greater diversification benefit.