Assessing Hedge Fund Risk

1. Assessing Hedge Fund Risk Assessment of risk is one of the primary aspects of due diligence when evaluating a potential hedge fund. Because hedge funds are designed to obtain absolute growth despite market conditions, there are many areas where the short term volatility of a particular investment may cause some high-risk funds to lose value. Understanding these risks requires an objective means of measuring the volatility and how it relates to the investment strategies employed by the fund manager. Just as the management styles and portfolio holdings are different from fund to fund, so too may be the type of assessment used to evaluate risk. Most diligent hedge fund managers use several different types of financial equations to evaluate volatility, and thus risk, in any given portfolio. In general, managers will use one or more of the following to assess risk: The Sharp Ratio, The Sortino Ratio, or The Sterling Ratio. These are not the only measures of volatility and risk, but they are some of the more common measures used. When evaluating a particular level of risk, it is important to choose the right type of evaluation in order to get numbers that are meaningful and directly related to the types of investments within the fund. The Sharp Ratio measures risk-adjusted performance. In terms of risk, the standard deviation of portfolio returns is used as a measure. The return is then adjusted for a known risk-free asset, such as a Treasury bills or some other asset that has a guaranteed return.

2. The Sortino Ratio measures the amount of incremental return that can be obtained per level of risk. The Sortino ratio uses the downside deviation to measure volatility. In this method of measuring volatility, an acceptable rate of return must be assigned - typically this is set at 0% for hedge funds, but that is not always the case. The Sterling Ratio divides the annualized return of the portfolio by the average yearly maximum drawdown, minus a certain percentage. Drawdown is a measure of loss over time. It starts with the beginning of the loss and continues until the stock or other asset begins to improve - this measure, taken over time, is the maximum drawdown. My analyzing this drop in prices, the hedge fund manager can assess the amount of negative volatility, and therefore, make an educated assessment of the risk. It is important to remember that none of these ratios are absolutes. They are only estimates of potential investment viability, and as a result, are only as accurate as the estimations of the hedge fund managers themselves. Keeping track of volatility with regards to hedge funds is prudent on several fronts. Positive volatility can be used to make large gains in a relatively short amount of time. And by hedging against negative volatility, the successful hedge fund investor can curb losses that would result in poor returns for investors. You must have a manager you trust when it comes to evaluating the numbers presented - an over or underestimation could skew results to the point that they are meaningless with regards to volatility measure. Paradigm Capital Management is an expert hedge fund managing firm. The firm also launches and manages equity mutual funds and hedge funds for its clients.

3. Paradigm Capital Management, Inc. was founded in 1972 and is based in Albany, New York with an additional office in New York City. Call at (518) 431-3500. Or visit here: http://www.paradigmcapital.com/