Three general types of benchmarks could be considered for hedge funds: (1) broad market indexes, (2) risk-free rate, and (3) hedge fund peer universes. However, they present some problems.
Broad market indexes are not appropriate to use as a benchmark for hedge funds because hedge funds cover a wide range of investment strategies.
The risk-free rate with an added spread could be used for some hedge fund strategies that focus on arbitrage. Unfortunately, the vast majority of hedge funds will carry some systematic risk, and the use of leverage will only exacerbate the risk. As a result, the spread would need to be increased accordingly. As with broad market indexes, the lack of correlation of hedge fund returns and the risk-free rate makes the risk-free rate an unsuitable benchmark.
Hedge fund peer universes are not suitable because a specific peer group’s risk and return objectives are not likely to match those of a specific hedge fund. Additionally, peer universes are subject to backfill and survivorship bias. Because of the frequent illiquidity of underlying assets in hedge funds, current pricing may not be exact and may be based on an appraisal or prior period price. As a result, there may be a smoothing effect, which reduces the reported standard deviation, thereby increasing the Sharpe ratio and the allocation to hedge funds.
Many real estate benchmarks exist but they are not all suitable for real estate investments:
- The benchmarks are derived from a sample of the real estate universe, which means they are not completely representative of the real estate asset class.
- The performance of the index probably bears a very high correlation to the largest investments.
- Benchmark returns are self-reported, so some subjectivity and/or bias may be present.
- Benchmarks that are value-based could be biased toward the most expensive properties or geographical areas.
- The use of appraisal data (e.g., infrequent pricing) leads to a smoothing effect and understated volatility or risk.
- There is a lack of comparability with benchmark returns given that some benchmarks use leverage while others do not.
- The indexes assume no transaction costs, full transparency, and normal liquidity, which is usually not the case; those factors would impact actual real estate returns.
Additionally, there is lack of consistency in the use of return measures.
Benchmarks exist to allow for performance comparisons specific private equity funds and that of a relevant peer group. The metric used is usually IRR, taking into account all investment cash flows since inception plus the ending investment value. Key problems with such benchmarks include managers using different methods of valuation, which makes comparison more difficult. In addition, IRR may be biased by losses or gains occurring near the beginning of an investment. Finally, all the results are reported at one common point in time, even though the firms are likely in varying stages of development.
Benchmarks for commodity investments are usually based on futures as opposed to actual assets. This may result in significant differences between the benchmark and the commodity investments portfolio, which reduces the comparability. Similar to other alternative investments, the different amounts of leverage employed by portfolios versus benchmarks—as well as the different weightings of exposures between portfolios and benchmarks—make the benchmarking process problematic for commodities.
Managed derivatives use specific benchmarks because of the lack of market indexes. As a result, such benchmarks may be too specific or not specific enough for a given investment strategy and, therefore, are not suitable. There are also peer group–based benchmarks, but as discussed previously, they are subject to problems such as stale pricing and survivorship and backfill bias.
Given the illiquidity and severe lack of marketability of distressed securities, it is almost impossible to determine an appropriate benchmark. Should the financial state of a distressed company become better, it may become more liquid. However, it is likely to require a significant amount of time to occur (if it even does) and that creates valuation problems (e.g., stale pricing).
Market indexes do exist such as the Barclay Distressed Securities Index; however, they may take into account numerous strategies so the suitability of indexes for a specific strategy is questionable. As well, the indexes may perform valuations at erratic intervals so the issue of stale pricing may not be solved.
Choosing the Right Benchmark
Useful performance evaluation (and any of its three components) requires an appropriate fund benchmark. When an incorrect benchmark is used in the performance evaluation process then performance measurement, which comprises attribution and appraisal analysis, will not be useful or provide valid information on understanding the investment process. Misspecified benchmarks will result in misfit active return.