Risk-Adjusted Performance of Funds of Hedge Funds Using a Modified Sharpe Ratio

TLDR

Many institutional investors use the traditional Sharpe ratio to examine the risk‑adjusted performance of funds of hedge funds, but its reliance on normal return assumptions can be problematic for this alternative asset class. The authors aim to rank 30 funds of hedge funds using both the traditional Sharpe ratio and a modified Sharpe ratio that incorporates a modified value‑at‑risk measure. They compute the traditional Sharpe ratio and a modified Sharpe ratio that replaces the standard deviation with a modified value‑at‑risk measure to account for non‑normal returns. The study finds that the modified Sharpe ratio is lower and more accurate for evaluating non‑normal returns, providing a superior tool for measuring risk‑adjusted performance.

Abstract

Many institutional investors use the traditional Sharpe ratio today to examine the risk-adjusted performance of funds of hedge funds (FOFs). However, this could pose problems due to the non-normal returns of this alternative asset class. A modified value at risk (VaR) and modified Sharpe ratio solves the problem and can provide a superior tool for correctly measuring risk-adjusted performance. In this article, the authors rank 30 funds of hedge funds according to the Sharpe and modified Sharpe ratio. Their results indicate that the modified Sharpe is lower and more accurate when examining non-normal returns.