A hedge fund reports 18% gross. After fees your client receives 13.8%. The prospectus said "2 and 20." Track where every basis point went and decide whether the result is any good.
You describe performance appraisal of an alternative investment the same way you would for a stock fund: return per unit of risk. The trouble is that alternative returns violate the assumptions behind the traditional ratios. Hedge fund, private equity, and private real estate returns are not normally distributed. They show negative skew, fat tails, and serial correlation from stale or appraisal-based pricing.
KEY: The Sharpe ratio assumes returns are normally distributed and independent. Alt returns satisfy neither. Reported Sharpes for hedge funds and private real estate are systematically overstated.
- Smoothing occurs when managers value illiquid positions using stale prices or appraisals. Reported volatility falls below true economic volatility, inflating Sharpe.
- Survivorship bias removes failed funds from index histories, inflating average index returns.
- Backfill bias appears when newly listed funds add only their best historical track record to a database.
Common mistakes
- Using Sharpe ratio for illiquid alts. Smoothed pricing depresses reported volatility and inflates Sharpe. Trap: ranking a private real estate fund above a public real estate investment trust (REIT) by Sharpe and concluding it has superior risk-adjusted return.
- Confusing MOIC and IRR. MOIC ignores time. IRR weights cash flows by timing. Examples 3 and 4 both return 2.00x, yet the IRRs are 14.87% and 20.52%. Trap: picking the higher MOIC as the better fund without checking horizon.
- Soft vs hard hurdle. Soft hurdle pays incentive on the full profit once the hurdle is cleared. Hard hurdle pays incentive only on excess above the hurdle. In Example 1 the hard-hurdle net return is 13.8%. Trap: 12.8%, the soft-hurdle answer.
Bottom line
- Sharpe ratio misleads for alt investments because returns are non-normal, illiquid, and smoothed. Sortino uses downside deviation, Calmar uses max drawdown, Treynor uses beta
- Net return = gross return, minus management fee, minus incentive fee, computed in that order unless the contract calculates the fees independently
- Hard hurdle: incentive on profit above the hurdle. Soft hurdle: incentive on all profit once the hurdle is cleared
- The management fee base (beginning, average, ending, committed) changes the fee; ending value costs more in an up year
Exam shortcut
Fees: find each fee's base first. The default order is gross, management, incentive, with the incentive fee on the gain after the management fee, unless the terms say the fees are calculated independently. For hurdles, look for what the fee is charged on, not the verb: a hard hurdle charges only on profit above the hurdle, a soft hurdle charges on all profit once the hurdle is cleared.
The full lesson (about 4,032 words, 27 min read) adds 10 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- performance and returns
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