How should you rank hedge funds

 

Most investors would say that you should rank hedge funds based on their Sharpe ratio, but there are fundamental problems with Sharpe that may not adequately measure risk. The Sharpe can be gamed with option strategies and does not account for characteristics beyond volatility. Hence, there are many who argue that using drawdown-based measures may be a better way. Research on the surface suggests that there is little difference in rank measures based on the high rank correlation across different performance measures, but a closer look says that these metrics are not all the same and picking the right performance measure matters.

Investors can classify performance measures based distributional assumption (Sharpe or Sortino) or investors can focus on drawdown analysis such as the Calmar or Sterling. Finally, there also are measures that account for the whole distribution of performance returns. Research suggest that ranking firms based on different performance is not always going to give you the same answer. See "Assessing Hedge Fund Performance: Does The Choice of Measures Matter?". This an older study that provides useful insights for investors. 

The rankings of hedge funds are highly correlated. it is found that all ranking across metrics seem to be the same with correlations well above .95. However, when there is an assessment of the equality of ranks, there is a different story.  There can be large divergences in the ranking based on different 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 based on a change in the performance measure. Nevertheless, in some cases, the rankings from some performance metrics show persistence when looked at in quartiles; however, there is no persistent when focused directly on ranks.

The traditional measures like Sharpe, Sortino, and Calmar all show persistence and seem to lead to stable rankings over time. Investors may use other measures, but an ensemble of performance metrics may be a helpful tool for rankings managers.