In its paper Apples and Apples, AIMA explained that informed investors also look at the value of the return in terms of the degree of risk taken since they prefer to have steadier returns with lower volatility than higher ones with greater volatility.
The paper said this is due to the risk of potential loss that higher volatility brings.
According to AIMA, while hedge funds outperform equities and bonds on a headline return basis over a 10 and 20-year period, they also outperform on a five-year period if the risk-adjusted returns of the three different asset classes are considered.
“This risk-adjusted out-performance was for both hedge funds as a whole and funds operating ‘equity hedge’ strategies,” said the paper.
Risk-adjusted returns are calculated using standard deviation which measures the scale of fluctuation from the peak to the trough during a particular period of time.
“Standard deviation is a key metric for investors seeking smoother and more stable returns over the long term,” said the report.
AIMA compared the volatility of hedge funds with equities and bonds by comparing the HFRI Fund Weight Composite Index with the S&P 500 and the Barclays Global Aggregate ex-USD Bond Index.
It discovered hedge funds had lower volatility compared with both equity and bonds.
The paper argued that if investors are to make direct comparisons between hedge funds and equities, they should be made over the long term, as data in the short term can “create false impressions”.
“Comparing equity returns with hedge fund returns during a short-lived equities bull market, for example, may be misleading because many hedge fund strategies are designed to protect investments during drawdowns rather than necessarily outperforming during rallies,” the paper said.
“Investments that preserve capital during drawdowns will frequently outperform long-only investments over the long term because of the destructive impact of drawdowns.”
