LOS j: Discuss the issues in assigning benchmarks to hedge funds.

Q1. Which of the following would be regarded as the least appropriate method to measure the performance of a hedge fund?

A)   The Sharpe ratio.

B)   Relative performance comparisons with traditional benchmarks.

C)   Separate long/short benchmarks.

Q2. The Sharpe ratio has become a commonly used performance measure for hedge funds. Which of the following statements in relationship to the use of the Sharpe ratio in the assessment of hedge fund performance is FALSE?

A)   The Sharpe ratio is the excess returns to the volatility encountered in earning them.

B)   A hedge fund’s Sharpe ratio can be compared to that of a universe of similar hedge funds.

C)   The use of derivatives positions in a hedge fund removes most of the skewness in returns making the use of standard deviations appropriate.

Q3. With regard to the use of value added return in the measurement of hedge fund performance, which of the following statements is TRUE?

A)   Although weights sum to zero a return is calculated by summing the performance impacts of the individual long positions.

B)   Value added return is calculated as the difference between the portfolio return, given benchmark weightings, and the actual portfolio return.

C)   Value added return is simply the difference between the portfolio return and the benchmark return.

LOS j: Discuss the issues in assigning benchmarks to hedge funds. fficeffice" />

Q1. Which of the following would be regarded as the least appropriate method to measure the performance of a hedge fund?

A)   The Sharpe ratio.

B)   Relative performance comparisons with traditional benchmarks.

C)   Separate long/short benchmarks.

Correct answer is B)

Construct a separate long and short benchmark, which can then be combined together in their relevant proportions. The Sharpe ratio compares the return to risk free rather than a benchmark. Relative performance using traditional benchmarks is the least appropriate given hedge funds concentration on absolute returns and the lack of reliable traditional benchmarks.

Q2. The Sharpe ratio has become a commonly used performance measure for hedge funds. Which of the following statements in relationship to the use of the Sharpe ratio in the assessment of hedge fund performance is FALSE?

A)   The Sharpe ratio is the excess returns to the volatility encountered in earning them.

B)   A hedge fund’s Sharpe ratio can be compared to that of a universe of similar hedge funds.

C)   The use of derivatives positions in a hedge fund removes most of the skewness in returns making the use of standard deviations appropriate.

Correct answer is C)

It is clear that for a significant number of hedge funds returns demonstrate a significant degree of skewness often created by the use of derivative positions. The other statements are correct.

Q3. With regard to the use of value added return in the measurement of hedge fund performance, which of the following statements is TRUE?

A)   Although weights sum to zero a return is calculated by summing the performance impacts of the individual long positions.

B)   Value added return is calculated as the difference between the portfolio return, given benchmark weightings, and the actual portfolio return.

C)   Value added return is simply the difference between the portfolio return and the benchmark return.

Correct answer is C)

To replicate a zero net asset hedge fund the weights must add to zero, not 1.0. Calculation of return is achieved by summing the individual long and short positions.