Evanston Capital Management has published a white paper examining methods of evaluating performance for hedge funds and other investments.
Hedge funds are often criticised within the investment community for poor performance compared to the S&P 500. However, such a comparison is inadequate for hedge funds or other investments, according to the paper – How To Evaluate Hedge Funds Or Any New Investment: Alphas, Sharpe Ratios, and The Underutilised – But Most Important – Appraisal Ratio.
Rather, investors should be evaluating new investments based on the ability to increase the total portfolio’s Sharpe Ratio in keeping with modern portfolio theory (MPT). One way to accomplish this is through use of the lesser-known Appraisal Ratio. Although historically underutilised, this ratio enables investors to simultaneously account for and evaluate an investment’s expected return, risk, and diversification attributes. This paper discusses why the Appraisal Ratio is critical to investment evaluation in MPT, how it is calculated and the common misperceptions held with regard to portfolio performance evaluation.
“As a former finance professor, I am always taken aback by how many investors are ignoring basic modern portfolio theory when evaluating the performance of hedge funds and other investments within their portfolios,” says Peter Hecht, vice president, senior investment strategist, Evanston Capital Management. “There is also a tendency to focus too much on an individual investment’s Sharpe Ratio, expected return and correlation properties and not enough on beta-adjusting returns and risk-adjusting alphas.”
