Hedge Funds and Std. Dev.

So I thought that standard deviation wasn’t a good risk measure for hedge funds due to the optionality that hedge funds employ. However, the CFAI text says that hedge funds can use standard deviation as a risk measure? Am I getting this confused? Maybe I’m just thinking about not using standard deviation for emerging markets.

Std Dev is a good risk measure if you can assume a normal distribution of returns. Hedge Funds tend to have more extreme returns due to their leveraged nature. As a result std dev isn’t a great measure of risk for them. However, because of its simple calculation and wide understanding it can still be used as a rough approx. Can you point to where in the text you read that the CFAi advocates using this as the measure of choice? (As usual… someone correct me if I’m wrong)

Sure. It’s in the Portfolio Evaluation section. It’s problem #16 of Reading 46. The answer on page 202 (last paragraph) states that std. dev. could be used. Kinda of confusing.

yeah, this particular topic is all ova the place. they do say std dev can be used but they are also quick to say that it assumes normality so may not be the best measure for HFs, given their asymmetrical strategies. in one place, they do say that downside deviation is a good measure too, because it uses a target return level.

I think in that context they are using it a little loosely using “can”. It cannnn be done but in comparison vs. the other readings I think it would be more important knowing the reasons why Sharpe isn’t the best measure. -assumes no correlation which can lead to auto correlation which artificially inflates Sharpe Ratio the reduced sd measure. -is a stand alone measure -if hedge funds don’t provide timely and accurate reporting info artificially lowers risk and increases sharpe -has to be normally distributed as CF_AH stated. (otherwise kurtosis and skewness) -doesn’t consider diversification. -doesn’t account for all risk (like writing out of the money call options)

Agree, interesting contradiction. To add to the general -ves: +assumes liquidity +reliant on historical data +time dependant nature of measure (S.D > @ root(t)), so must compare over same time horizon.