Most investors would say you should rank hedge funds by their Sharpe ratio, but Sharpe has fundamental problems that may not adequately measure risk. The Sharpe ratio can be gamed with option strategies and does not account for characteristics beyond volatility. Hence, many argue that drawdown-based measures may be better. Research suggests little difference in ranking measures because of high rank correlation across performance measures, but a closer look shows these metrics are not the same, and choosing the right performance measure matters.
Investors can classify performance measures based on distributional assumptions (Sharpe or Sortino), or investors can focus on drawdown analysis such as the Calmar or Sterling. Finally, some measures account for the full distribution of performance returns. Research suggests that ranking firms based on different performance measures does not always yield the same results. See "Assessing Hedge Fund Performance: Does The Choice of Measures Matter?". This older study provides useful insights for investors.
Hedge fund rankings are highly correlated. All rankings across metrics seem to be the same, with correlations well above .95. However, when assessing the equality of ranks, the story is different. Rankings can diverge widely across metrics. The performance measures are not all the same. Investors may mis-rank managers based on their choice of performance measure. About 1/5 of firms will move to a different rank decile when the performance measure changes. Nevertheless, in some cases, rankings from certain performance metrics show persistence when viewed in quartiles; however, there is no persistence when focusing directly on ranks.
Traditional measures like Sharpe, Sortino, and Calmar show persistence and seem to produce stable rankings over time. Investors may use other measures, but an ensemble of performance metrics may help rank managers.
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