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The Choice of Performance Measure Does

Influence the Evaluation of Hedge Funds
ARTICLE JANUARY 2010
DOI: 10.2139/ssrn.1403246

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The Choice of Performance Measure Does Influence

the Evaluation of Hedge Funds
Valeri Zakamouline
This revision: October 28, 2009

Abstract
It is widely accepted that, when return distributions are non-normal, the use of the
Sharpe ratio can lead to misleading conclusions. It is well documented that deviations of
hedge fund return distributions from normality are statistically significant. The literature
on performance evaluation that takes into account the non-normality of return distributions
is a vast one. However, there is another stream of research that advocates that the choice of
performance measure does not influence the evaluation of hedge funds. For example, Eling
and Schuhmacher (2007) and Eling (2008) performed empirical studies and, judging by the
values of rank correlations, concluded that the choice of performance measure is irrelevant.
The goal of this paper is to explain the reasons for extremely high positive rank correlations
in the above cited studies and reassert the reader that the choice of performance measure
does influence the evaluation of hedge funds.
Key words: hedge funds, performance measures, portfolio performance evaluation,
Sharpe ratio, rank correlation, non-normality, skewness, kurtosis.
JEL classification: D81, G11.

The author is grateful to Philippe Cogneau, Steen Koekebakker, Svetlozar T. Rachev, and Frank Schuhmacher for their comments and the Ehedge AG for providing a database of hedge fund returns. The usual
disclaimer applies.

University of Agder, Faculty of Economics, Service Box 422, 4604 Kristiansand, Norway, Tel.: (+47) 38 14
10 39, Valeri.Zakamouline@uia.no

Introduction

The literature on portfolio performance measurement starts with the seminal paper of Sharpe
(1966) who proposed a reward-to-risk measure now widely known as the Sharpe ratio. However,
it is broadly accepted that because the Sharpe ratio is based on the mean-variance theory, it
is valid only for either normally distributed returns or quadratic preferences (see, for example,
Tobin (1969)). Thus, when return distributions are non-normal, the Sharpe ratio can lead
to misleading conclusions and unsatisfactory paradoxes. For instance, it is well known that
deviations of hedge fund return distributions from normality are often statistically highly
significant (see, for example, Brooks and Kat (2002), Agarwal and Naik (2004), and Malkiel
and Saha (2005)). Therefore, performance evaluation of hedge funds using the Sharpe ratio
seems to be dubious since the standard deviation is not able to adequately measure the risk.
There have been proposed many alternative risk measures and it is well documented in the
literature that the composition of the investors optimal portfolio crucially depends on how
the investor measures the risk (see, for example, Marmer and Ng (1993), Agarwal and Naik
(2004), Biglova, Ortobelli, Rachev, and Stoyanov (2004), Jarrow and Zhao (2006), Rachev,
Jasic, Stoyanov, and Fabozzi (2007), and Farinelli, Ferreira, Rossello, Thoeny, and Tibiletti
(2008)).
However, there is a stream of research that advocates that the choice of performance measure does not influence the evaluation of risky portfolios. For example, Eling and Schuhmacher
(2007) and Eling (2008) computed the rank correlations between the rankings according to
some alternative performance measures, including the Sharpe ratio, and found that the rankings are extremely positively correlated. The authors concluded that the choice of performance
measure is irrelevant, since, judging by the values of rank correlations, all measures give virtually identical rankings. Yet, this conclusion seems to be rather puzzling because alternative
performance measures use quite different approaches to performance measurement. The goal
of this paper is to explain the reasons for extremely high positive rank correlations in the
studies by Eling and Schuhmacher (2007) and Eling (2008) and reassert the reader that the
choice of performance measure does influence the evaluation of hedge funds.
In this paper we use basically the same datasets as in Eling and Schuhmacher (2007), but
the design of our study is different. In particular, the aim of our study is to try to find: (1)

the alternative performance measures that can produce rankings that are distinctly different
from that of the Sharpe ratio ranking; (2) how the method (nonparametric versus parametric)
of computation of performance measures influences the rank correlations; (3) whether or not
a high value of the Spearmans rank correlation coefficient really implies virtually identical
rankings; (4) how the characteristics of a sample of hedge fund returns influence the rank
correlation; (5) the role of higher moments of distribution in performance evaluation; (6)
whether or not the length of the investment horizon matters in performance evaluation. To
limit the length of the paper, we restrict the number of alternative performance measures to the
most popular performance measures based on lower and upper partial moments of distribution
and the Value-at-Risk (VaR) concept, and focus only on the study of the differences between
rankings according to some alternative performance measures and the Sharpe ratio. Below we
briefly present our findings.
First, the studies of Eling and Schuhmacher (2007) and Eling (2008) are based on using
a small subset of all available alternative performance measures (in fact, now the number of
alternative performance measures amounts to more than a hundred, see Cogneau and Hubner
(2010)). Indeed, conducting a study that covers all alternatives to the Sharpe ratio seems to
be a tremendous task. Yet, one can always suspect that among the performance measures
that have not been used in these studies there might be some measures that produce clearly
distinct results. We find that there are indeed some measures that can produce quite low rank
correlations with the Sharpe ratio. Among these measures are the Rachev ratio (and, hence,
the generalized Rachev ratio, see, Biglova et al. (2004)) and Farinelli-Tibiletti ratio (see Section
2 for references).
Second, the conclusions in the studies by Eling and Schuhmacher (2007) and Eling (2008)
are based solely on the values of Spearmans rank correlation coefficients. Yet, it is known
that there is no clear interpretation of a particular value for the Spearmans correlation coefficient (see, for example, Noether (1981)). Thus, a value of a Spearmans rank correlation
coefficient can be misleading. We provide a deeper investigation of the differences between the
rankings according to alternative performance measures and the Sharpe ratio ranking. Our
findings suggest that despite rather high rank correlations the rankings produced by alternative performance measures are far from being identical to the ranking produced by the Sharpe
ratio. In particular, we find that on average each hedge fund experiences a move in ranking
3

by approximately one decile in the sample. Approximately 30% of funds experience change in
ranking by more than 1.5 decile in the sample, and the maximum change in ranking amounts,
on average, to 4 deciles.
Third, in the studies by Eling and Schuhmacher (2007) and Eling (2008) the majority of
return distributions are close to normal. For example, in the study by Eling and Schuhmacher
(2007) the assumption of normally distributed hedge fund returns must be rejected for approximately 40% of the funds at the 1% significance level. Therefore, 60% of hedge funds in their
study have practically normally distributed returns. In the study by Eling (2008) from 50% to
80% of funds have practically normally distributed returns. Since the majority of alternative
performance measures try to account for non-normality of return distributions, it is difficult
to see any clear differences in rankings if the percentage of funds with normally distributed
returns is rather large. In addition, to see clear differences in rankings one needs to have a
sample of funds with distinctly different probability distributions of returns. That is, even if
the probability distributions of funds in a sample are obviously non-normal but basically of the
same kind of deviation from normality (for example, if probability distributions belong to the
class of elliptical distributions), then again the differences in rankings according to alternative
performance measures might be negligible. Moreover, the fact that deviations from normality are statistically significant does not imply that deviations from normality are economically
significant.
We provide a study of the cross-section of the deviations of hedge fund return distributions
from normality and find that even though most of the return distributions in our sample are
statistically non-normal, the deviations from normality are usually not severe: the majority
of hedge fund return distributions have relatively low absolute skewness and either close to
normal or moderately high kurtosis. Since for the great deal of funds there is no apparent
distinction between the shape of the empirical probability distribution and the shape of the
normal probability distribution, for these funds the deviations from normality might be economically insignificant. We demonstrate that all alternative performance measures used in our
study produce the same ranking of risky assets as the Sharpe ratio when either the probability
distributions are normal or one, while implementing a parametric computation of performance
measures, assumes the normality of distributions. As a consequence, if either the deviations
of hedge fund return distributions from normality are insignificant, or one uses a paramet4

ric computation method under assumption of normality, then the rank correlation between
the rankings according to the Share ratio and an alternative performance measure becomes
extremely high or even perfect. We demonstrate that if we retain in the sample the funds
with the highest absolute values of skewness, then the rank correlation with the Sharpe ratio
decreases. Furthermore, we discover that hedge funds with larger Sharpe ratios experience
greater shifts in their rankings. That is, a rank correlation between the rankings produced by
an alternative performance measure and the Sharpe ratio depends on the values of the Sharpe
ratios of hedge funds in a sample under investigation.
Forth, in the studies by Eling and Schuhmacher (2007) and Eling (2008) the performance
measures are computed using monthly returns. As a consequence, the findings in these studies
are valid only for investors that have one month investment horizon. In fact, the literature on
theoretical and empirical performance measurement has given little attention to the horizon
to be employed in the computation of performance measures. In empirical studies one works
with a dataset of returns with some particular sampling period whose length varies from one
day to one year, most often one has monthly return data. Suppose that we compute different
performance measures and rank portfolios using a short sampling period. Would the ranking
of portfolios remain the same for an investor with a longer holding period? Not necessarily!
We demonstrate that the rank correlations with the Sharpe ratio depend on the investment
horizon and there are plenty of alternative performance measures that exhibit decreasing rank
correlation as horizon increases.
Paraphrasing the conclusions reached by Eling and Schuhmacher (2007) and Eling (2008),
the higher moments of distribution do not matter in performance evaluation. To reinforces
the important findings of our empirical analysis and demonstrate that higher moments do play
significant roles in performance evaluation, we perform a simulation analysis of alternative performance measures. In particular, using a simulated sample of return distributions we conduct
a regression analysis to investigate the role played by skewness and kurtosis in performance
evaluation using alternative performance measures. We find that both skewness and kurtosis
play significant roles in performance evaluation. We discover, however, that the effect of skewness is more dominant than the effect of kurtosis. Besides, our regression analysis confirms
that the sensitivities of an alternative performance measure to the skewness and kurtosis of
a return distribution depend on the value of the Sharpe ratio of a return distribution. Our
5

simulation analysis also allows to compare the sensitivities of alternative performance measures
to higher moments of distribution.
The rest of the paper is organized as follows. In Section 2 we present the portfolio performance measures used in our study and in Section 3 we demonstrate that these measures
produce the same ranking of risky assets as the Sharpe ratio under the normality assumption.
In Section 4 we remind the reader that depending on the choice of performance measure an
investor can arrive at different investment decisions when the shapes of return distributions
are distinctly different. Moreover, using as an example the investors choice between investing
in the stock and to pursue a portfolio insurance strategy, we demonstrate that skewness plays
important role in financial decision-making. Section 5 aims to demonstrate that the use of the
Sharpe ratio for long-term investment decisions produces a systematic bias as compared to the
use of an alternative performance measure that accounts for higher moments of distribution.
In Section 6 we perform the empirical study of the hedge fund performance evaluation and
the robustness check of our findings. In Section 7 we conduct the simulation and regression
analysis. Section 8 concludes the paper.

Performance Measures Used in this Study

In this section we present the portfolio performance measures used in our study. Throughout
the paper we denote by x the return on a risky portfolio and by r the risk-free rate of return.
We remind the reader that the Sharpe ratio is given by

SR(x) =

E[x] r
,
x

where E[x] is the expected value and x is the standard deviation of x respectively.
The definition of a lower partial moment of order n at some level is given by (see, for
example, Fishburn (1977))
Z
LP Mn (x, ) =

( s)n dFx (s),

where Fx is the cumulative distribution function of x. Similarly, an upper partial moment of

order n at some level is defined by

Z
U P Mn (x, ) =

(s )n dFx (s).

The level is usually interpreted as a minimal acceptable return or the investors reference
return. In the majority of cases the reference return is chosen to be the risk-free rate of return.
In our study we employ the following performance measures based on partial moments of
distribution: the Sortino1 ratio, the Omega2 ratio, the Kappa3 ratio, the Upside potential4
ratio, and the Farinelli-Tibiletti5 ratio. These ratios are given by

Sortino ratio = p

Omega ratio =

E[x] r
LP M2 (x, r)

U P M1 (x, r)
E[x] r
=
+ 1,
LP M1 (x, r)
LP M1 (x, r)

Kappa ratio =

E[x] r
1

(LP M (x, r))

U P M1 (x, r)
Upside potential ratio = p
,
LP M2 (x, r)
1

Farinelli-Tibiletti ratio =

(U P M (x, r))
1

(LP M (x, r))

The Value-at-Risk of x at the confidence level 1 , (0, 1), is given by

V aR (x) = Fx1 (),
where Fx1 is the inverse of the distribution function Fx . Quite frequently the VaR measure is computed using the parametric approach under the assumption of normality of return
distributions. In this case the value of V aR (x) is given by
V aR (x) = (E[x] + x z ),
1

See Sortino and Price (1994).

See Shadwick and Keating (2002). This ratio is also known as the Bernardo-Ledoit gain-loss ratio, see
Bernardo and Ledoit (2000).
3
See Kaplan and Knowles (2004). This ratio is also known as the Sortino-Satchell ratio.
4
See Sortino, van der Meer, and Plantinga (1999).
5
See Farinelli et al. (2008) and references therein.
2

where z is -quantile of the standard normal distribution. The conditional VaR (CVaR, a.k.a.
the Expected Shortfall, the Expected Tail Loss) is given by
1
CV aR (x) = E[x|x V aR (x)] = E[x 1xV aR (x) ].

If x is normally distributed, then

z2
1
2
CV aR (x) = E[x] e
.
2
The most popular VaR-based performance measures include the reward-to-VaR6 ratio, the
reward-to-Conditional VaR7 ratio, and the Rachev8 ratio. These ratios are given by

Reward to VaR ratio =

E[x] r
,
V aR (x r)

Reward to Conditional VaR ratio =

Rachev ratio =

E[x] r
,
CV aR (x r)

CV aR (r x)
.
CV aR (x r)

The advantage of CVaR over VaR lies in that CVaR satisfies certain plausible axioms, see
Artzner, Delbaen, Eber, and Heath (1999). In particular, VaR does not satisfy the subadditivity axiom. As a consequence, in some cases VaR does not encourage diversification
which was heavily criticized in the literature on risk measurement. The Rachev ratio can be
interpreted as the ratio of the expected tail return above a certain level to the expected tail
loss below some certain level. Thus, this ratio awards extreme returns adjusted for extreme
losses.

Performance Measurement under Normality Assumption

This section aims to demonstrate that the alternative performance measures produce the same
ranking of risky assets as the Sharpe ratio when either the probability distributions of hedge
6

See Dowd (2000), Favre and Galeano (2002), and Alexander and Baptista (2003).
See Martin, Rachev, and Siboulet (2003), Tasche and Tibiletti (2004), Biglova et al. (2004), and Stoyanov,
Rachev, and Fabozzi (2007). The reward-to-CVaR ratio is also known as the STARR ratio.
8
See Biglova et al. (2004) and Rachev et al. (2007).
7

funds are (multi-)normal or one, for the sake of simplification of computations, assumes that
the probability distributions of hedge funds are normal. As an immediate consequence, if the
deviations of hedge fund return distributions from normality are insignificant, then the rank
correlation between the rankings according to the Share ratio and an alternative performance
measure becomes very high.
We consider first the reward-to-VaR ratio under the normality assumption. In this case it
can be written as

Reward to VaR ratio =

E[x] r
SR(x)
=
.
(E[x r] + x z )
(SR(x) + z )

Similarly, under the normality assumption, we can write the reward-to-CVaR and Rachev
ratios in terms of the Sharpe ratio

Reward to Conditional VaR ratio =

SR(x)

,
2
z
SR(x) 12 e 2
2
z

Rachev

SR(x) + 12 e 2
.
ratio =
2
z
SR(x) 12 e 2

Observe that every ratio can be written in the following form

(x) =

a + SR(x)
,
b SR(x)

where (x) is a performance measure, and a and b are some non-negative constants. Note
that every VaR-based performance measure is a strictly increasing function of the Sharpe ratio
since
d(x)
a+b
=
> 0.
dSR(x)
(b SR(x))2
Consequently, if SR(x1 ) > SR(x2 ) then necessarily (x1 ) > (x2 ).
Next we consider rankings produced by the performance measures based on partial moments
of distribution under the assumption of normality.
The Kappa ratio generalizes both the Sortino and Omega ratios. It can be easily shown
that the Kappa ratio is the performance measure of the investor with the following utility
9

function
U (x) =

xr

when x r,

(r x) (r x)

when x < r,

(1)

where > 0 and > 0 are some real numbers. This utility function is concave below r and
linear above r. Thus, the investor equipped with this function is risk averse below and risk
neutral above r respectively.
The Farinelli-Tibiletti ratio, in its turn, generalizes the Omega and Upside potential ratios.
The Farinelli-Tibiletti ratio is the performance measure of the investor with the following utility
function
U (x) =

(x r)

when x r,

(r x)

when x < r,

(2)

where > 0, > 0, and > 0 are some real numbers. The values of and define whether
the investor is risk averse, risk neutral, or risk seeking above and below r respectively. If = 1,
the investor is risk neutral above r. If 0 < < 1, the investor is risk averse above r. In contrast,
if > 1, the investor is risk seeking above r. Similarly, if = 1, the investor is risk neutral
below r. If 0 < < 1, the investor is risk seeking below r. Finally, if > 1, the investor is risk
averse below r. Thus, the Farinelli-Tibiletti ratio is very flexible with respect to defining the
investors risk preferences. The risk preference of the investor within Expected Utility Theory
can be defined by > 1 and 0 < < 1. Prospect Theory of Kahneman and Tversky (1979)
assumes that the investor is risk seeking below and risk averse above the reference point. One
can model these preferences using 0 < < 1 and 0 < < 1. Markowitz (1952) suggested
that, in order to explain why all people buy insurance and lottery tickets, the investors utility
function must be concave below and convex above the reference point. These preferences can
be modelled by > 1 and > 1.
It is straightforward to conclude that the performance measures based on partial moments
of distributions are, in fact, the utility based performance measures. Levy and Kroll (1976)
analyzed the impact of inclusion of a risk-free asset in the investment portfolio on stochastic
dominance rules. These authors show that in case of normal distributions the stochastic dominance rule is equivalent to the Sharpe ratio rule for all nondecreasing utility functions. In other
words, if distributions are normal and in the presence of a risk-free asset every investor with

10

nondecreasing utility function prefers the portfolio with the highest Sharpe ratio. Obviously,
utility functions (1) and (2) are always increasing. Therefore, if distributions are normal, the
performance measures based on partial moments produce the same ranking as the Sharpe ratio.

Performance Measurement When Return Distributions are

Distinctly Different

The goal of this section is to remind the reader that depending on the choice of performance
measure an investor can arrive at different investment decisions when the shapes of return
distributions are distinctly different. Moreover, we demonstrate, by means of an example, that
skewness plays important role in financial decision-making.
It is well documented in the literature that the composition of the optimal portfolio crucially
depends on the risk measure being used. For example, Marmer and Ng (1993) and Jarrow
and Zhao (2006) demonstrated that, if return distributions are distinctly non-normal, then
mean-semivariance optimal portfolios are significantly different from mean-variance optimal
portfolios. Agarwal and Naik (2004) compared the risk-return tradeoffs provided by hedge
funds using the mean-variance and mean-CVaR frameworks. In particular, these authors first
constructed a mean-variance and a mean-CVaR efficient frontiers and then compared and
contrasted the differences in the efficient frontiers. They found that the expected tail loss of
mean-variance optimal portfolios can be underestimated by as high as 54% compared with
mean-CVaR optimal portfolios. Biglova et al. (2004), Rachev et al. (2007), and Farinelli
et al. (2008) considered the construction of optimal portfolios using different performance
measures. These authors showed that in case the return distributions are distinctly nonnormal the investors optimal portfolio crucially depends on how the investor measures the
portfolio risk and reward.
Now we turn to the demonstration of the fact that when the shapes of return distributions
are distinctly different, then the usage of different performance measures may lead to different
rankings. This demonstration also highlights the conclusions obtained by Marmer and Ng
(1993), Agarwal and Naik (2004), Biglova et al. (2004), Jarrow and Zhao (2006), Rachev et al.
(2007), Farinelli et al. (2008), and many others. The demonstration is done by means of an
example. In this example we consider the investors choice between two distinct buy and hold
11

strategies. The first strategy consists in investing in the stock, whereas the second strategy is
to pursue a 100% portfolio insurance strategy. The latter consists in buying a put option on
every share of the stock. Using the put-call parity, the 100% portfolio insurance strategy is
equivalent to investing in the call options on the stock and the bank.
The optimality of the portfolio insurance strategy has always been debated. Despite the
growing popularity of dynamic portfolio insurance strategies in the early 1980s due to the
activities of Leland OBrien Rubinstein Associates, Jacobs (1983) presented the first critique
of this policy. In particular, using the historical estimates of the parameters of the S&P500
stock index, he noted that the Sharpe ratio of the S&P500 stock index is higher than the
Sharpe ratio of a call option on the index. Consequently, he concluded that the portfolio
insurance is not optimal. In contrast, the converse strategy, namely the sale of put or call
options on the stock, turns to be optimal for the investor with the mean-variance preferences,
see, for example, Leland (1999), Spurgin (2001), and Goetzmann, Ingersoll, Spiegel, and Welch
(2002). What we are going to show is that for an investor with more sound risk preferences, as
compared with using standard deviation to measure the risk, the portfolio insurance strategy
often turns to be optimal.
Assume the Black-Scholes economy where the stock portfolio price evolves according to a
diffusion process given by
dP = P dt + P dW,

(3)

where and are, respectively, the mean and volatility of the stock portfolio returns per unit
of time, and W is a standard Brownian motion. Consequently, if the current price of the stock
portfolio is P0 , then the price of the stock portfolio at some future time T is given by
PT = P0 e(0.5

2 )T +

Tz

(4)

where z is a normally distributed variable with mean 0 and variance 1. The call option payoff
at time T is given by
CT = max(PT K, 0),
where K is the strike price. The continuously compounded risk-free interest rate, r, is assumed
to be constant. The reader is reminded that the stock return distribution is approximately

12

normal when the investment horizon is short. By contrast, the call return distribution is
distinctly non-normal with low left-tail risk and high upside return potential.
We simulate the future stock portfolio price 1,000,000 times and compute the returns of
the stock portfolio and the call portfolio (assuming the call option price is computed using the
Black-Scholes formula). Then using the returns we compute different performance measures
for the stock and call portfolios. The results of the return simulations and the computations of
performance measures are presented in Table 1. From the table we see that the stock portfolio
should be preferred to the call portfolio if one uses the Sharpe ratio as the selection criterion.
By contrast, most of the alternative performance measures imply that the investor should
prefer the call portfolio. That is, in this example the usage of an alternative performance
measure usually leads to the opposite decision as compared with the usage of the Sharpe ratio.
Finally it is worth noting that in some cases the investors decision depends on the strike price
in the call option contracts.
[Insert Table 1 about here]

Performance Measurement Over Longer Investment Horizons

This section aims to demonstrate that the use of the Sharpe ratio for long-term investment
decisions produces a systematic bias as compared to the use of an alternative performance
measure that accounts for higher moments of distribution. In particular, if a long-term investor
employs the Sharpe ratio to construct the optimal risky portfolio, such a portfolio includes a
large proportion of assets with low standard deviations. Alternatively, a long-term investor
that uses the Sharpe ratio to select a single asset from a universe of mutually exclusive assets
tends to select an asset with low standard deviation.
For the sake of simplicity of demonstration, suppose that prices of all assets follow the
diffusion process given by (3). Consequently, the return of an asset over period T is given by

x=

PT P0
,
P0

where PT is given by (4). The expected return and the standard deviation of return over T
13

are easily calculated

E[x] = eT 1,

x = eT

e2 T 1.

(5)

Consequently, the Sharpe ratio of an asset

SR(x) =

eT erT
p
.
eT e2 T 1

(6)

Levy (1972) was the first to show that if the returns are independent and identically distributed
over time then, while the expected returns and standard deviations both increase with holding
period, the rate of increase is greater for standard deviation. Moreover, the rate of increase
in standard deviation is much greater for assets with high mean returns and volatilities (see
(5)). As a result, over long horizons the Sharpe ratios of assets with low standard deviations
eventually become greater than the Sharpe ratios of assets with high standard deviations even
though for short horizons the situation was directly opposite. Later on the implications of the
result of Levy (1972) were studied by Gunthorpe and Levy (1994), Asness (1996), and Hodges,
Taylor, and Yoder (1997).
However, the result of Levy (1972) stems from a serious drawback in using standard deviation as a risk measure. Namely, standard deviation treats similarly variability in losses and
variability in gains. In particular, standard deviation penalizes for both downside and upside
variabilities in returns. Yet, a rational investor treats losses and gains separately and would
rather consider high variability in gains as an attractive reward potential. Already Markowitz
(1959) was fully aware of this drawback of standard deviation and acknowledged that downside
deviation is a better risk measure than standard deviation.
The computation of skewness of the lognormal distribution over T gives
2
p
Skew[x] = e T + 2
e2 T 1.

Apparently, assets with higher standard deviations exhibit greater (positive) skewness of return
distribution which is commonly considered as an attractive feature for a rational investor (see,
for example, Kraus and Litzenberger (1976) and Kane (1982)). It turns out that a higher
rate of increase in standard deviation for assets with higher volatilities is mainly due to higher
increase in upside variability in returns. In other words, over long horizons assets with higher
14

volatilities exhibit much higher right-tail reward potential than assets with lower volatilities.
Unfortunately, standard deviation does not appreciate positive skewness, but, on the contrary,
penalizes it.
To illustrate the result of Levy (1972) and demonstrate that over long horizons alternative performance measures produce different ranking with that of the Sharpe ratio, consider
the following example. In this example we compute different performance measures of two
lognormally distributed assets, which we will refer to as the stocks, using different lengths of
investment horizon. The model parameters are: 1 = 0.10, 1 = 0.15, 2 = 0.20, 2 = 0.35,
r = 0.05, and T takes values in [1, 2, . . . , 7] years. The results of computations are presented in
Table 2. Observe that stock 1 has lower volatility than stock 2. According to the Sharpe ratio,
stock 2 outperforms stock 1 if the length of the investment horizon is less than approximately
3.4 years. However, for longer investment horizons stock 1 outperforms stock 2. Note that
when T = 3.4 both stocks have approximately the same expected returns and standard deviation of returns. According to the Sharpe ratio criterion, both stocks are equally attractive.
However, when T = 3.4 stock 1 has skewness of 0.87, whereas stock 2 has skewness of 2.53.
That is, stock 2 has much greater right-tail reward potential and a rational investor should
prefer this stock. Finally note that all alternative performance measures used in our study
indicate that stock 2 outperforms stock 1 for any length of the investment horizon.
[Insert Table 2 about here]

6
6.1

Empirical Study of Hedge Fund Performance Evaluation

Data and Methodology

Data Sample
The hedge fund data are obtained from the Ehedge AG (note that this is the same data
provider as in Eling and Schuhmacher (2007)), a German financial services company founded
in 2000 by the LCF Rothschild Group and BMP Venture Capital. The company provides
hedge fund information and other services to institutional investors (see www.ehedge.de). As
of May 2008, the Ehedge database contained 3921 individual hedge funds reporting monthly
net-of-fee returns for the time period from October 1969 to May 2008. The database includes
15

770 (19.64%) surviving funds and 3151 (80.36%) dissolved funds.

Our sample consists of all hedge funds in the database that have no missing observations of
returns during the 10-years period from January 1997 to December 2006 which makes a total
of 120 monthly observations. The total number of hedge funds in our sample is 270.9 The
return distributions of hedge funds are analyzed in Table 3. The table shows the mean, the
median, the standard deviation, the minimum, and the maximum of the first four moments
of the monthly return distributions (mean value, standard deviation, skewness, and kurtosis).
On basis of the Jarque-Bera test, the assumption of normally distributed hedge fund returns
must be rejected for 73.15% (79.03%) of the funds at the 1% (5%) significance level.
[Insert Table 3 about here]
Table 4 presents additional information about the cross-section of the probability distributions of hedge funds in our sample. In particular, this table presents the empirical distribution
of hedge fund returns according to the degrees of skewness and kurtosis. This table illustrates
that even though most of the hedge fund return distributions in our sample are statistically
non-normal, the deviations from normality are usually not severe: the majority of hedge fund
returns have rather low absolute skewness and either close to normal or moderately high kurtosis. Thus, on average, the deviations from normality might be economically insignificant. If
this is the case, the account for non-normality of return distributions made by an alternative
performance measure might be negligible for the majority of funds.
[Insert Table 4 about here]
Computation of Portfolio Performance Measures
All performance measures used in our study are computed using the nonparametric estimation
method. The rolling 90 day T-bill rate is used as the risk-free rate of return. We vary the
length of investment horizon in [1, 6, 12, 24] months. Since our sample is rather short and, for
example, consists of only 5 non-overlapping investment horizons of 2 years, to overcome this
difficulty we use a nonparametric bootstrap method. Since the hedge fund returns may exhibit
9

Our choice represents a compromise between the number of observations and the number of funds. We
could either extend the period at the expense of decreasing the number of funds in the sample, or increase the
number of funds in the sample at the expense of decreasing the length of period.

16

a strong degree of serial correlation (see, for example, Lo (2002)), we employ the moving block
bootstrap method introduced by Carlstein (1986) and Kunch (1989). This method was used
by, for example, Hansson and Persson (2000), Lin and Chou (2003), and Jan and Wu (2008)
to estimate the parameters of distribution over longer horizons. This method preserves all
possible time dependencies in the return series.
Specifically, for a k-months investment horizon, we first randomly pick a month, say q,
between 1 and (120 k + 1) with equal probability, and then, starting with this month, we
compound the returns to get a k-months holding period return. Then we repeat the procedure
5,000 times. Hedge fund returns and risk-free rate of return are simulated cross-sectionally, so
they belong to the same time period in the original series.
Since the Farinelli-Tibiletti ratio is very flexible with regard to defining the investors
preferences, we decided to use the following three distinct sets of parameters and : (1) =
0.5, = 2 defines the preferences of an investor within Expected Utility Theory (everywhere
risk averse); (2) = 1.5, = 2 defines the Markowitz (1952) investor who is risk seeking above
r; (3) the preferences of the investor with = 0.8, = 0.85 largely correspond to the investor
within Prospect Theory of Kahneman and Tversky (1979) (risk seeking behavior below r and
risk averse above r).
Computation of Rank Correlations
As it is commonly done in the literature, to find out whether or not a performance measure
produces different ranking as compared to that of the Sharpe ratio, we find rank correlation
between the rankings according to two measures and assess the value of the correlation coefficient. In statistics, rank correlation is the study of relationships between different rankings on
the same set of data. It measures the correspondence between two rankings and assesses its
significance. Two of the most popular rank correlation statistics are the Spearmans rank correlation coefficient (Spearmans rho) and the Kendalls rank correlation coefficient (Kendalls
tau, see Kendall (1962)). To the best of the authors knowledge, in all studies on the rank
correlations between different portfolio performance measures the authors have always employed the Spearmans rank correlation only. However, as Noether (1981) observes, there is no
any theoretical reasons for preferring the Spearmans rank correlation to the Kendalls rank
correlation.
17

A correlation coefficient is intended to measure the strength of relationship. Different correlation coefficients measure strength of relationship in different ways, but only the Kendalls
coefficient has a simple interpretation. Ease of the interpretation of the rank correlation coefficient is very important, and interpretation of a particular value for the Spearmans rho is
unclear. In contrast, the Kendalls tau has a clear interpretation. Suppose we evaluate the
performance of hedge funds using two different measures. Address the question what is the
probability p that the two performance measures produce the same ranking of hedge funds?
Then the Kendalls tau is an estimate of (2p 1).

6.2

Findings

Performing the empirical analysis of how the degree of a rank correlation with the Sharpe
ratio depends on the properties of a sample of hedge funds, we discovered that hedge funds
with larger Sharpe ratios experience greater shifts in their rankings if we employ alternative
performance measures. Apparently, the larger the Sharpe ratio, the larger the adjustment for
non-normality of return distribution made by an alternative performance measure. In other
words, our findings suggest that the larger the Sharpe ratio, the larger the sensitivity of an
alternative performance measure to higher moments of distribution.
Table 5 presents the Kendalls rank correlations between the rankings according to the
alternative performance measures and the ranking according to the Sharpe ratio for different
lengths of the investment horizon and different sub-samples of hedge funds. From the table we
observe that the rankings according to the alternative performance measures usually exhibit
rather high positive correlation with the ranking according to the Sharpe ratio. Yet, the
Farinelli-Tibiletti and Rachev ratios are examples of performance measures that can exhibit
quite low rank correlations with the Sharpe ratio.
[Insert Table 5 about here]
Table 5 also demonstrates that the rank correlation depends on the length of the investment
horizon. Some alternative performance measures exhibit a decreasing rank correlation with
the Sharpe ratio as horizon increases, whereas the other exhibit an increasing rank correlation.
Furthermore, the results presented in Table 5 confirm that the differences between the rankings
according to an alternative performance measure and the Sharpe ratio increase when the hedge
18

fund return distributions becomes more asymmetrical. In particular, if we retain in the sample
the hedge funds with the highest values of skewness, the rank correlation with the Sharpe ratio
decreases. Finally, these results demonstrate that the rank correlations with the Sharpe ratio
decrease if we retain in the sample the hedge funds with the largest Sharpe ratios. Whereas
for the total sample and one month investment horizon the average rank correlation with the
Sharpe ratio amounts to 0.75, for the sub-sample containing funds with the highest Sharpe
ratios and two years investment horizon the average rank correlation drops to 0.42.
Since the rank correlations with the Sharpe ratio are rather high and positive for the
majority of alternative performance measures (at least for short investment horizons and the
total sample of hedge funds), one is tempted to jump to the conclusion that the use of the
Sharpe ratio produces the ranks that are virtually identical to the ranks produced by alternative
performance measures. As Eling (2008) writes (see page 64) What I showed, however, that
in almost all practical decision-making problems, the results of using the Sharpe ratio and of
using the other measures are so close that which of the different measures is used makes almost
no difference.
To demonstrate that a high rank correlation with the Sharpe ratio does not really imply
almost identical rankings, we calculate the maximum upgrade, maximum downgrade, mean
absolute change, and standard deviation of the change in the rankings of hedge funds according
to the alternative performance measures with respect to the ranking according to the Sharpe
ratio. Table 6 presents these results. The table demonstrates that even for short investment
horizons there are some hedge funds in the sample that experience dramatic change in ranking
if the performance measure is changed from the Sharpe ratio to an alternative performance
measure. For example, for the 1-month Upside potential ratio the maximum changes in ranking
amount to an upward movement over 67% and a downward movement over 40% of funds in
the sample (this corresponds to an upgrade by 138 places and a downgrade by 95 places).
For the same ratio the average mean absolute change in ranking amounts to 11.7 percentiles
(31.1 places) with the standard deviation of the change in ranking of 16.0 percentiles (42.8
places). For the 1-month Rachev ratio the maximum changes in ranking amounts to an upward
movement over 74% of funds in the sample and a downward movement over 87% of funds (this
corresponds to an upgrade by 201 places and a downgrade by 240 places). For the same ratio
the average mean absolute change in ranking amounts to 26.7 percentiles (69.3 places) with
19

the standard deviation of the change in ranking of 34.1 percentiles (87.2 places). Even for the
1-month Omega ratio that has the highest rank correlation with the Sharpe ratio the maximum
downgrade in ranking amounts to a downward movent over 44% of funds in the sample (this
correspond to a downgrade by 112 places). On average, each hedge fund experiences a move
in ranking by approximately one decile in the sample. Approximately 30% of funds experience
change in ranking by more than 1.5 decile in the sample, and the maximum change in ranking
amounts to approximately 4.5 deciles. The information in this table suggests that despite
rather high rank correlation the ranking produced by alternative performance measures is far
from being identical to the ranking produced by the Sharpe ratio.
In fact, performance measures are used mainly for the purpose of identifying the best
fund to investment in, or to compare the performance of a fund with the performance of
some benchmark. Our results therefore imply that an investor might be way too wrong in
his choice if he, instead of using an appropriate (alternative) performance measure, relies
on the Sharpe ratio to select the best hedge fund. Similarly, an evaluator of a hedge fund
manager might be way too wrong in his conclusion if he uses the Sharpe ratio to compare
the performance of the hedge fund with the performance of a benchmark. Figure 1 provides
additional illustration of the fact that the ranking produced by an alternative performance
measure is far from being identical to the ranking produced by the Sharpe ratio. In particular,
this figure shows the ranks of hedge funds according to the Sortino and Rachev ratios versus
the ranks according to the Sharpe ratio for 2 years investment horizon. The plots presented in
this figure clearly demonstrate the big differences between rankings according to the Sharpe
ratio and an alternative performance measure.
[Insert Table 6 about here]
[Insert Figure 1 about here]

6.3

Robustness Check

In this subsection we perform a robustness check of our findings. For this purpose we use
two alternative databases of hedge fund returns (these two databases are the same that were
used by Eling and Schuhmacher (2007) in their robustness check). The first database is the
CS/Tremont Hedge Fund Indexes (see www.hedgeindex.com). The CS/Tremont indexes are
20

based on the TASS database which tracks around 2,600 hedge funds. Using a subset of around
650 funds CS/Tremont calculates 13 indexes (in addition to the main index) which track
every major style of hedge fund management. Our sample consists of monthly returns of the
CS/Tremont indexes from April 1994 to September 2009. The other database is the Hennessee
Hedge Fund Indexes (see www.hennesseegroup.com). The Hennessee Hedge Fund Indexes are
calculated from performance data reported to the Hennessee Group by a diversified group of
over 1,000 hedge funds. Our sample consists of 24 Hennessee Hedge Fund Indexes which have
monthly data from January 1996 to September 2009.
As for the Ehedge database, we perform a moving block bootstrap simulation of return
distributions, compute the performance measures, and then compute the rank correlations
as well as the maximum upgrade, maximum downgrade, mean absolute change, and standard
deviation of the change in the rankings of hedge funds according to the alternative performance
measures with respect to the ranking according to the Sharpe ratio. Since the number of return
observations in the alternative databases is greater, we increase the longest investment horizon
to 3 years.
Tables 7 and 8 report the results. The rank correlations reported in Table 7 are comparable
to those presented in Table 5 for the total sample. We see that on average the rank correlations
with the Sharpe ratio slightly decrease as the horizon increases, the only exceptions are the rank
correlations for 1 month investment horizon. Moreover, the rank correlation for each alternative
performance measure exhibits a particular dependence on the length of the investment horizon.
The changes in the rankings reported in Table 8 are also comparable with those presented in
Table 6 for 2 years investment horizon. In particular, on average each hedge fund experiences
a move in ranking by approximately one decile in the sample. Approximately 32% of funds
experience change in ranking by more than 1.5 decile in the sample, and the maximum change
in ranking amounts, on average, to 3.5 deciles.
[Insert Table 7 about here]
[Insert Table 8 about here]

21

Simulation Analysis of Portfolio Performance Measures

In this section we perform a simulation analysis. The idea is to simulate a large sample of
return distributions with greater deviations from normality as compared with the empirical
sample. The simulation also allows to define the values of the Sharpe ratios of the simulated
return distributions. The purpose of the simulation analysis is two-fold. First of all, the simulation analysis reinforces two important findings of our empirical analysis, namely, that the
rank correlation with the Sharpe ratio decreases as either the deviations of return distributions
from normality become larger or the values of the Sharpe ratios of return distributions becomes
greater. Second, using the simulated sample of return distribution we perform a regression and
compute the sensitivities of alternative performance measures to higher moments of distributions. This allows us not only to find out how sensitive the different performance measures to
higher moments of distribution, but also to demonstrate that higher moments play significant
roles in performance evaluation.
In our simulation analysis we employ the normal inverse Gaussian (NIG) distribution
(see, for example, Barndorff-Nielsen (1995) and Barndorff-Nielsen (1998)). The reasons for
this choice are the following: (1) the NIG distribution generalizes the normal distribution
and allows to define the values of skewness and kurtosis of the probability distribution; (2)
distributions of risky asset returns can often be fitted extremely well by the NIG distribution
(see the references in Barndorff-Nielsen (1998)); (3) for the NIG distribution we have explicit
formulas for finding the parameters of the distribution via the values of the first four moments
of the distribution. Note, however, that to get meaningful parameters of the NIG distribution
the following condition must be satisfied
5
Kx > 3 + Sx2 ,
3

(7)

where Sx and Kx are the skewness and kurtosis of x respectively.

First of all, we simulate a sample of return distributions with different values of the Sharpe
ratio, skewness, and kurtosis. In particular, we simulate return distributions using a threedimensional grid (SR, Sx , Kx ). We vary the skewness Sx [5, 5] with step 1, the kurtosis
Kx [3, 67] with step 4, and the Sharpe ratio SR [SRmin , SRmax ] with step 0.1. Note that

22

due to condition (7) we generally start with some minimum possible value for the kurtosis,
not from the value of 3. For each triple of parameters of a return distribution, (SRi , Sj , Km ),
we simulate 10,000 return values which make a sample of returns of a single hypothetic hedge
fund.
Having simulated the total sample of return distributions, we then compute the Sharpe ratio
and alternative performance measures, rank distributions, and finally compute the Kendalls
rank correlation coefficients between the rankings according to the Sharpe ratio and the alternative performance measures. Afterwards we estimate the parameters of the following model
for each alternative performance measure
(x) = SR (x)eS Sx +K EKx + ,

(8)

where (x) is an alternative performance measure, is an error term, and EKx is the kurtosis
minus the minimum possible kurtosis given some value of skewness (this is related to condition
(7))
5
EKx = Kx 3 Sx2 .
3
After the linearizing log-log transformation of (8) it takes the form

log((x)) = log() + log(SR(x)) + S Sx + K EKx + ,

where the parameters (, , S , K ) can be estimated using the techniques of ordinary linear
regression.
The motivation for model (8) is the following. Observe that
(x) = SR (x),

, > 0

(9)

is a performance measure which is equivalent to the Sharpe ratio in the sense that both the
Sharpe ratio and produce the same ranking of return distributions. Consequently, if an
alternative performance measure produces virtually identical ranking with the Sharpe ratio,
then after the estimation of (9) we should obtain a very high goodness of fit given by the
value of R-square (R2 ) statistics. The factor eS Sx in (8) is an adjustment factor for skewness

23

of distribution. If the value of skewness influences the value of an alternative performance

measure, then after the estimation of (8) we should obtain a statistically significant value of S .
Similarly, eK EKx is an adjustment factor for kurtosis of distribution. If the value of kurtosis
influences the value of an alternative performance measure, then after the estimation of (8)
we should obtain a statistically significant value of K . Overall, if an alternative performance
measure produces virtually identical ranking with the Sharpe ratio, then the goodness of fit
of (8) should not be significantly better than the goodness of fit of (9). We use EKx instead
of Kx 3 in (8) because in this case the goodness of fit is usually better (according to our
experiments). Indeed, a part of the value of kurtosis accounts for the value of skewness.
EKx represents a true excess kurtosis which is the standard kurtosis minus the minimum
possible kurtosis in a probability distribution given the value of skewness. Note that the
values of S and K can be interpreted as the (relative) sensitivities to skewness10 and kurtosis
respectively. That is, if, for example, some performance measure has a greater value of S
than some other performance measure, it means that the percentage change in the value of the
former performance measure is greater than the percentage change in the value of the latter
performance measure with respect to the same change in skewness.
The results of the regression and rank correlation analysis are presented in Table 9. To
demonstrate how the values of the Sharpe ratios of return distributions influence the rank
correlation and the goodness of fit of models (8) and (9), for each performance measure we
use two non-overlapping ranges for the Sharpe ratio: [0.1, 0.4] and [0.5, 0.8]. In all cases we
found that the values of the parameters , , S , K are statistically significant at the 1% level
for all alternative performance measures. This says, in particular, that the values of skewness
and kurtosis play significant roles in performance measurement. The value of S is positive11
which means that all alternative performance measures appreciate positive skewness. The
value of K is negative with a few exceptions which means that most often an alternative
performance measure penalizes excess kurtosis. It is important to note that for all alternative
performance measures the sensitivity to skewness is much greater than the sensitivity to excess
10

(x)

Sx
Indeed, S = (x)
. This demonstrates that S is the relative sensitivity of the performance measure given
by model (8) to the skewness of distribution.
11
With only one exception, namely, for the Farinelli-Tibiletti0.8,0.85 ratio and the Sharpe ratio interval
[0.1, 0.4]. Recall that the Farinelli-Tibiletti0.8,0.85 ratio is the performance measure of the investor with preferences implied by Prospect Theory. This investor is risk seeking below the reference point, hence, such an
investor prefers distributions with high downside deviations.

24

kurtosis. In particular, the sensitivity to skewness is 10-40 times greater than the sensitivity
to excess kurtosis. This means, for example, that a decrease in skewness by 1 produces the
same adjustment of a performance measure as an increase in excess kurtosis by 10-40.
[Insert Table 9 about here]
From Table 9 we see that approximately half of the alternative performance measures have
rather high rank correlation with the Sharpe ratio if we use a set of return distributions with
low Sharpe ratios. For example, when SR [0.1, 0.4] the Farinelli-Tibiletti0.5,2 ratio has the
rank correlation of 0.84. The sensitivity of this ratio to the skewness of distribution is 0.020.
For this ratio the goodness of fit of model (8) is 0.93, whereas the goodness of fit of model (9)
is 0.88. That is, the adjustment for skewness and kurtosis of return distribution made by this
performance measure seems to be negligible when the Sharpe ratio is low. A similar picture
is observed for the Omega and Farinelli-Tibiletti0.8,0.85 ratios. However, the picture changes
dramatically if we use a set of return distributions with high Sharpe ratios. For example, when
SR [0.5, 0.8] the rank correlation between the Farinelli-Tibiletti0.5,2 and the Sharpe ratios
drops to 0.47. The sensitivity of this ratio to the skewness of distribution jumps to 0.097,
that is, it increases practically in 5 times. For the same ratio the goodness of fit of model
(9) collapses to 0.24 which means that the Sharpe ratio explains only 24% of the variation in
the Farinelli-Tibiletti0.5,2 ranking. Overall, whereas for a set of distributions with low Sharpe
ratios the ranking according to the Sharpe ratio explains up to 88% of the variation in an
alternative ratio ranking, for a set of distributions with high Sharpe ratios the Sharpe ratio
ranking explains only up to 40% of variation in ranking.
The Farinelli-Tibiletti1.5,2 ratio has the largest sensitivities to higher moments of distribution when a set of distributions has low Sharpe ratios. An increase in the value of in the
Kappa ratio also helps to increase the sensitivity to higher moments of distribution when a
set of distributions has low Sharpe ratios. For the alternative performance measures based
on the VaR concept, the lower the confidence level, the higher the rank correlation with the
Sharpe ratio, and the lower the sensitivities to the higher moments of distribution. The ranking
according to the Rachev ratio usually exhibits very low rank correlation with the Sharpe ratio
ranking. This ratio also has very high sensitivities to higher moments of distribution. Whereas
for this ratio the goodness of fit of model (8) is rather high, the goodness of fit of model (9)
25

is extremely poor. The latter means that the ranking according to the Sharpe ratio explains
almost no any variation in the Rachev ratio ranking irrespective the values of the Sharpe ratios
of hedge funds in a sample.

Conclusions

In this paper we performed theoretical, empirical, and simulation analysis of rank correlations
between some alternative performance measures and the Sharpe ratio. In contrast to Eling and
Schuhmacher (2007) and Eling (2008) who concluded that the choice of performance measure
is irrelevant, our conclusion is that the choice of performance measure does influence the evaluation of hedge funds. In our opinion, the results of Eling and Schuhmacher (2007) and Eling
(2008) are mainly due to: (1) particular choice of alternative performance measures and in
some cases using the parametric method under assumption of normality in the computations
of performance measures; (2) use of short sampling periods to compute alternative performance
measures; (3) use of datasets with very large percentage of fund that have nearly normal distribution of returns; (4) conclusions are based solely on the values of Spearmans rank correlation
coefficients without any deep analysis of differences in rank correlations. We demonstrated
that there are some performance measures which produce rather low rank correlations with
the Sharpe ratio. Our empirical and simulation analysis showed that the rank correlation with
the Sharpe ratio depends also on the length of sampling period and some characteristics of
a sample of hedge fund returns. Our deeper analysis of the differences between the rankings
according to alternative performance measures and the Sharpe ratio ranking suggests that despite rather high rank correlations the rankings produced by alternative performance measures
are far from being identical to the ranking produced by the Sharpe ratio. Moreover, we found
that both skewness and kurtosis play important roles in performance evaluation.

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Tasche, D. and Tibiletti, L. (2004). Approximations for the Value-at-Risk Approach to RiskReturn Analysis, The ICFAI Journal of Risk Management, 1 (4), 44 61.
Tobin, J. (1969). Comment on Borch and Feldstein, Review of Economic Studies, 36 (1), 13
14.

30

Measure

Stock

Sharpe
Sortino
Kappa3
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.10
Reward-to-VaR0.05
Reward-to-CVaR0.05
Rachev0.05,0.05

0.227
0.442
0.339
1.807
0.991
0.454
1.393
1.749
0.236
0.186
0.153
1.783

K = 80
0.220
0.453
0.366
1.762
1.044
0.460
1.488
1.661
0.206
0.203
0.203
2.534

K = 90
0.207
0.470
0.397
1.720
1.117
0.454
1.638
1.550
0.264
0.264
0.264
3.640

Call
K = 100
0.189
0.497
0.442
1.683
1.219
0.423
1.890
1.412
0.337
0.336
0.337
5.445

K = 110
0.167
0.539
0.498
1.668
1.339
0.360
2.267
1.269
0.419
0.419
0.420
8.369

K = 120
0.142
0.594
0.566
1.678
1.463
0.275
2.802
1.135
0.510
0.510
0.511
12.992

Table 1: The performance measures of the stock and call portfolios for different strikes. The model
parameters are: the initial stock price P0 = 100, the stock drift = 15%, volatility = 30%, the
risk-free rate of return r = 5%, the length of the investment horizon T = 0.5 years. For the simplicity
of comparison we underline the values of a performance measure of the call portfolio when it is greater
than the value of the corresponding performance measure of the underlying stock portfolio.

31

Performance
measure
Sharpe
Sortino
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.05
Reward-to-CVaR0.05
Rachev0.05,0.05

Asset
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock
Stock

1
0.323
0.386
0.667
1.023
2.313
2.958
0.335
1.546
0.597
0.758
1.584
2.152
2.345
2.954
0.273
0.417
0.219
0.348
1.772
2.732

1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2
1
2

2
0.444
0.492
1.105
1.855
3.287
4.703
0.707
2.356
0.855
1.210
2.107
3.252
3.465
4.827
0.440
0.744
0.348
0.622
2.268
4.214

Holding period, years

3
4
5
6
0.527 0.591
0.641
0.682
0.544 0.567
0.574
0.570
1.536 1.983
2.455
2.957
2.792 3.883
5.167
6.683
4.318 5.447
6.698
8.090
6.782 9.315 12.415 16.210
1.069 1.439
1.832
2.243
3.275 4.350
5.619
7.123
1.126 1.410
1.725
2.059
1.734 2.328
3.054
3.883
2.616 3.149
3.714
4.335
4.546 6.086
7.938 10.124
4.648 5.973
7.516
9.217
7.028 9.902 13.312 17.572
0.607 0.772
0.949
1.126
1.094 1.497
1.965
2.492
0.475 0.603
0.733
0.867
0.924 1.262
1.644
2.099
2.737 3.224
3.720
4.263
5.940 8.085 10.636 13.763

7
0.715
0.558
3.494
8.479
9.642
20.854
2.687
8.906
2.428
4.871
4.987
12.932
11.192
22.811
1.326
3.133
1.011
2.603
4.830
17.527

Table 2: Performances of two lognormally distributed stocks over different lengths of the investment
horizon. The model parameters are: 1 = 0.10, 1 = 0.15, 2 = 0.20, 2 = 0.35, and r = 0.05.

Fund
Mean value (%)
Std. deviation (%)
Skewness
Kurtosis

Mean
0.96
3.86
-0.08
8.01

Median
0.88
3.23
0.06
5.53

Std. dev.
0.48
2.84
1.44
9.96

Min
-0.38
0.13
-9.81
2.44

Max
3.48
15.52
3.92
103.62

Table 3: Descriptive statistics for 270 hedge fund monthly return distributions.

Kurtosis
<5
(5, 10)
> 10
Sum

< 1.5
0
6
24
30

(1.5, 0.5)
10
25
4
39

Skewness
(0.5, 0.5)
89
41
2
132

Sum
(0.5, 1.5)
15
32
2
49

> 1.5
0
6
14
20

114
110
46
270

Table 4: Distribution of hedge fund monthly returns according to the values of skewness and kurtosis
in the total sample of 270 hedge funds.

32

Performance ratio
Sortino
Kappa3
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.05
Reward-to-CVaR0.05
Rachev0.05,0.05
Average

0.87
0.83
0.91
0.67
0.82
0.56
0.88
0.86
0.84
0.24
0.75

1/12
(0.78/0.78)
(0.76/0.61)
(0.86/0.81)
(0.56/0.60)
(0.82/0.71)
(0.45/0.44)
(0.85/0.82)
(0.86/0.77)
(0.76/0.63)
(0.22/0.13)
(0.69/0.63)

0.82
0.77
0.89
0.77
0.88
0.68
0.88
0.81
0.76
0.33
0.76

Horizon, years
1/2
1
(0.69/0.53) 0.79 (0.67/0.48)
(0.62/0.49) 0.77 (0.68/0.45)
(0.82/0.64) 0.84 (0.73/0.56)
(0.61/0.53) 0.79 (0.66/0.51)
(0.80/0.68) 0.87 (0.75/0.65)
(0.54/0.45) 0.73 (0.63/0.49)
(0.84/0.66) 0.86 (0.81/0.57)
(0.73/0.49) 0.77 (0.65/0.39)
(0.59/0.43) 0.77 (0.65/0.51)
(0.25/0.16) 0.47 (0.30/0.29)
(0.65/0.51) 0.76 (0.65/0.49)

0.76
0.76
0.76
0.75
0.81
0.71
0.80
0.70
0.72
0.53
0.73

2
(0.59/0.44)
(0.57/0.45)
(0.62/0.45)
(0.55/0.45)
(0.64/0.48)
(0.55/0.38)
(0.62/0.49)
(0.53/0.53)
(0.53/0.33)
(0.32/0.24)
(0.55/0.42)

Table 5: Kendalls rank correlations between the rankings according to the alternative performance
measures and the ranking according to the Sharpe ratio for different lengths of the investment horizon.
The first value in the brackets shows rank correlations if we retain in the sample 60 funds with the
highest absolute values of skewness. The second value in the brackets shows rank correlations if we retain
in the sample 60 funds with the highest Sharpe ratios and whose return distribution are non-normal at
the 0.1% significance level according to the Jarque-Bera test.

Performance
measure
Sortino
Kappa3
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.05
Reward-to-CVaR0.05
Rachev0.05,0.05
Average

Max
upgrade
26 (31)
47 (43)
10 (29)
67 (35)
49 (27)
64 (40)
14 (27)
27 (38)
28 (45)
74 (60)
41 (38)

Max
downgrade
25 (43)
26 (44)
44 (42)
40 (43)
19 (41)
65 (44)
68 (41)
74 (47)
29 (44)
87 (57)
48 (45)

Mean abs.
change
4.1 ( 8.5)
15.8 ( 8.9)
3.4 ( 7.9)
11.7 ( 8.6)
6.1 ( 7.1)
15.1 ( 9.9)
4.4 ( 7.2)
5.4 (10.6)
5.7 ( 9.3)
26.7 (16.5)
9.8 ( 9.5)

Std. dev.
change
6.0 (12.4)
22.3 (12.7)
5.6 (11.7)
16.0 (12.3)
8.8 (10.6)
20.3 (13.7)
7.5 (10.9)
9.1 (14.8)
8.1 (13.2)
34.1 (21.6)
13.8 (13.4)

Table 6: This table shows the maximum upgrade, maximum downgrade, mean absolute change, and
standard deviation of the change in the ranking of hedge funds according to the alternative performance
measures with respect to the ranking according to the Sharpe ratio for 1 month and 2 years investment
horizons (the latter values are in the brackets). Note that the mean change in the rankings is zero
by construction. The values are given in percentiles. Thus, for example, an upgrade by 30 percentiles
means an upward movement in ranking by 270 0.3 = 81 places.

33

Performance measure

Tremont

Hennessee

Tremont

Hennessee

Tremont

Hennessee

Hennessee

1/12
Tremont

Sortino
Kappa3
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.05
Reward-to-CVaR0.05
Rachev0.05,0.05
Average

Horizon, years
1
2

0.91
0.65
0.93
0.54
0.84
0.43
0.73
0.61
0.86
-0.07
0.64

0.86
0.79
0.92
0.52
0.88
0.37
0.81
0.87
0.79
-0.01
0.68

0.84
0.84
0.89
0.85
0.91
0.80
0.89
0.89
0.84
0.45
0.82

0.76
0.63
0.83
0.69
0.80
0.63
0.87
0.84
0.68
0.26
0.70

0.73
0.75
0.80
0.74
0.86
0.74
0.89
0.71
0.77
0.45
0.74

0.75
0.68
0.86
0.76
0.82
0.71
0.87
0.79
0.78
0.57
0.76

0.69
0.71
0.79
0.69
0.71
0.71
0.79
0.57
0.72
0.54
0.69

0.70
0.65
0.78
0.67
0.73
0.66
0.80
0.78
0.77
0.60
0.71

Table 7: Results of robustness tests. This table reports Kendalls rank correlations between the
rankings according to the alternative performance measures and the ranking according to the Sharpe
ratio for different lengths of the investment horizon.

Tremont

Hennessee

Tremont

Hennessee

Std. dev.
change

Hennessee

Mean abs.
change

Tremont

Max
downgrade

Hennessee

Sortino
Kappa3
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.05
Reward-to-CVaR0.05
Rachev0.05,0.05
Average

Max
upgrade
Tremont

Performance
measure

38
31
31
38
31
31
23
33
42
41
34

33
38
17
33
29
38
17
24
24
38
29

31
31
23
31
31
31
23
25
33
33
29

54
54
33
54
33
58
29
41
52
67
48

10.7
10.6
8.3
10.7
8.3
10.7
5.9
11.1
13.9
16.7
10.7

10.1
12.2
7.3
10.1
7.3
11.1
6.6
9.7
11.8
14.5
10.1

16.6
15.7
12.6
16.6
13.7
15.7
10.4
16.3
19.8
22.5
16.0

16.4
18.4
11.5
16.3
12.4
18.5
10.5
16.0
14.8
21.7
15.7

Table 8: Results of robustness tests. This table reports the maximum upgrade, maximum downgrade,
mean absolute change, and standard deviation of the change in the ranking of hedge funds according
to the alternative performance measures with respect to the ranking according to the Sharpe ratio for
2 years investment horizon. The values are given in percentiles.

34

1
0.9

0.8

0.8

0.7

0.7

Rachev ratio percentile

Sortino ratio percentile

1
0.9

0.6
0.5
0.4
0.3

0.6
0.5
0.4
0.3

0.2

0.2

0.1

0.1

0.2

0.4
0.6
Sharpe ratio percentile

0.8

(a) Sortino versus Sharpe

0.2

0.4
0.6
Sharpe ratio percentile

0.8

(b) Rachev versus Sharpe

Figure 1: The ranks of hedge funds according to an alternative performance measure versus the
ranks according to the Sharpe ratio for 2 years investment horizon. To compare rankings based on
two measures we cross-plot the corresponding percentiles for the funds. The fund with the highest
value of a performance measure is assigned rank 1, whereas the fund with the smallest value of a
performance measure is assigned rank 270. Then the ranks are converted to percentiles, with rank 1
assigned percentile 1/270, rank 2 assigned percentile 2/270, and so on up to rank 270, which is assigned
percentile 1.0 (100%).

35

Performance
measure
Sortino
Kappa3
Omega
Upside potential
Farinelli-Tibiletti0.5,2
Farinelli-Tibiletti1.5,2
Farinelli-Tibiletti0.8,0.85
Reward-to-VaR0.05
Reward-to-VaR0.01
Reward-to-CVaR0.05
Reward-to-CVaR0.01
Rachev0.05,0.05
Rachev0.01,0.01

Sharpe ratio
interval
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8
0.1-0.4
0.5-0.8

0.086
0.124
0.108
0.135
0.026
0.099
0.071
0.115
0.020
0.097
0.109
0.128
-0.007
0.093
0.055
0.105
0.100
0.122
0.090
0.119
0.113
0.127
0.160
0.181
0.206
0.217

-0.003
-0.006
-0.008
-0.011
0.002
-0.001
-0.004
-0.008
-0.003
-0.005
-0.005
-0.009
0.004
0.001
0.005
0.008
-0.004
-0.005
-0.002
-0.003
-0.008
-0.008
-0.001
-0.004
-0.001
-0.005

Rank
correlation
0.69
0.36
0.60
0.32
0.81
0.46
0.50
0.34
0.84
0.47
0.30
0.25
0.80
0.50
0.75
0.47
0.66
0.39
0.69
0.41
0.62
0.35
0.14
0.13
0.08
0.05

R2
0.95
0.74
0.93
0.77
0.92
0.67
0.86
0.74
0.93
0.72
0.89
0.74
0.91
0.66
0.95
0.73
0.92
0.71
0.93
0.68
0.90
0.72
0.81
0.75
0.82
0.80

(0.75)
(0.17)
(0.61)
(0.13)
(0.86)
(0.29)
(0.41)
(0.14)
(0.88)
(0.24)
(0.18)
(0.09)
(0.86)
(0.36)
(0.87)
(0.40)
(0.71)
(0.20)
(0.76)
(0.22)
(0.62)
(0.16)
(0.04)
(0.03)
(0.01)
(0.01)

Table 9: The results of the regression and rank correlation analysis using a sample of simulated return
distributions. The values in the brackets for the R2 statistics show the goodness of fit of the model
(x) = SR (x). The values of the parameters S and K are statistically significant at the 1% level
for all alternative performance measures.

36