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.
Performance appraisal of an alternative investment usually starts with a risk-adjusted ratio meant to describe return per unit of risk, but those returns violate the assumptions behind 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. A fund with MOIC 1.5x over 10 years has a worse IRR than a fund with MOIC 1.5x over 5 years. 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. Trap: applying soft-hurdle math to a hard-hurdle fact pattern.
Bottom line
- Sharpe ratio misleads for alt investments because returns are non-normal, illiquid, and smoothed, which depresses reported volatility and inflates the ratio
- Better-suited ratios: Sortino uses downside deviation, Calmar uses max drawdown, Treynor uses beta
- "2 and 20" = 2% management fee on AUM/committed capital + 20% incentive fee on profits, often modified by a hurdle, catch-up, and high-water mark
- PE uses cash-flow metrics: IRR, MOIC, DPI (realized), RVPI (unrealized), TVPI = DPI + RVPI
Exam shortcut
Fees, always in this order: gross, management, incentive. Never apply incentive before management. For PE multiples: TVPI = DPI + RVPI, full stop. For hurdle wording, "must exceed" signals hard hurdle (pay on excess only) and "once exceeded" signals soft hurdle (pay on full profit). For ratio choice on illiquid or skewed alts, Sortino or Calmar beats Sharpe.
The full lesson (about 2,018 words, 13 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- performance and returns
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