AIRAP - ALTERNATIVE VIEWS ON ALTERNATIVE INVESTMENTS
The recognition by researchers and investors that the standard tools of portfolio theory and performance measurement are not generally applicable to hedge fund has resulted in a significant shift in the focus of research.
The good news is that investors armed with this knowledge are less likely to make incorrect inferences from the standard metrics. For example, Sharma notes that optimization of Fund of Funds portfolios on the basis of Sharpe Ratios will result in over-weighting non-directional strategies, which tend to have higher Sharpe Ratios (arising from low market betas), which in turn may result in unintended illiquidity and short volatility bias in the portfolio (as these are prominent characteristics of some non-directional strategies).
The bad news is that it takes a while before new metrics are developed, comparative studies are done, and conclusions are drawn about what’s best.
In this paper, Sharma uses a new performance measure (one of several new approaches presented in this volume) that addresses some of the known issues, namely, negative skewness and excess kurtosis in returns, the effect of leverage, and applicability when measured mean returns are negative.
Sharma’s method accomplishes this by assuming that investor’s utility for risk and return can be expressed by a particular, fairly general, class of utility functions. From this assumption it is possible to go in several directions. For example, it becomes simple to infer the risk premium that investors would demand from a hedge fund given its actual observed returns. Among other things, this allows investors to compare performance in much the same way that would be done using the Sharpe Ratio.
Sharma shows that traditional measures like, the Sharpe Ratio, Jensen’s Alpha and the Treynor ratio yield qualitatively very different conclusions about hedge fund performance than does the new measure, A.I.R.A.P.
Still, A.I.R.A.P.-measured performance of various styles reveals that hedge funds do indeed provide risk adjusted added value for investors. Additional support for this conclusion is found in Sharma’s analysis of persistence in hedge fund returns. Sharma finds strong persistence in returns on all hedge fund styles with the exception of two notoriously volatile (and typically highly directional) styles, Global Macro and CTA.
The expanded use of alternative metrics like A.I.R.A.P. for alternative investments, both in performance evaluation and in portfolio construction, can only benefit investors’ decision making.
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ERRATA AND OTHER MATERIAL
- Other research by Milind Sharma:
- Sharma, M., 2005, "‘Sharper’ Risk Adjusted Performance Measures (RAPMs): From Omega to AIRAP", HedgeQuest (Summer), pp. 13-16
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- Sharma, M., 2005, "Hedge Fund Investing", in Risk Management: A Modern Perspective, M. Ong, Editor, Amsterdam: Elsevier.
- SSRN website
- Related Research:
- Gregoriou, G., Editor, 2005, Hedge Funds: Insights in Performance Measurement, Risk Analysis, and Portfolio Allocation
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- Hedge Fund Indices:
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