The key to evaluating hedge fund performance is distinguishing between a fund that has made a lot of money through luck and one that has performed well thanks to informed decision making. Making this distinction can involve comparing the performance of different funds on a fair basis. Even when this is achieved, mathematical analysis can still give an improved insight into the issue of luck vs. judgment.
One of the most important points to consider when examining past performance is how the fund performed in comparison to other similar funds. By their vary nature, financial markets as a whole go through good and bad periods. This may mean that a great hedge fund manager only achieves a little growth during a tough time for the markets, while a mediocre hedge fund manager makes a large return during a boom. To take this into account, investors can compare a hedge fund's performance to that of the entire financial market in question over the same period.
The time period is also an important factor. It is hardly unknown for hedge fund performance figures to show results only for a carefully chosen period. At its least subtle, this would simply involve showing growth figures since the fund's all time low position; most funds aren't this blatant, but generally, looking for results dating back a several years is a good idea. Take into account, though, that going too far back may result in looking at results from a period when the fund was managed in a different way or by different staff.
Simply making bigger returns than the market as a whole or other funds isn't necessarily a sign of skilled judgment. To get past this limitation, some investors try to compare the returns a fund has achieved to the amount of risk it has taken. One way of doing this is the Sharpe ratio, which involves taking the return a fund has achieved, deducting the level of return that would have been achieved from a virtually risk-free investment such as government securities, and then dividing the result by a figure representing the amount of variation between the high and low points of the fund's investments. The lower the Sharpe ratio, the likelier it is that the fund was lucky to pick stocks that varied wildly and happened to fall in its favor, rather than the fund taking calculated risks to achieve strong but steady growth.
Which method a person uses to look at hedge fund performance depends exactly what he wants from his investment. Every investor has an individual judgment on the correct balance of risk and return for his needs. An investor's particular balance determines exactly what he looks for when deciding how well funds have performed in the past.
Of course, it is vital to remember that past performance is not a guarantee of future results. This may seem cliché, but it is true. The very best evaluation of hedge fund performance may serve as an indication of the underlying skills and the chances of the fund succeeding in future, but there's no certainty this will come to fruition.
