With most mutual funds, calculating performance is a fairly straightforward endeavor. Simply calculate the net asset value (NAV) of all the assets in the fund by adding up the value of all the securities in the portfolio, and subtracting any liabilities, such as borrowed money. Add back any dividends issued as if they were reinvested in the fund. Divide the NAV at the end of the period by the NAV at the beginning of the period, and subtract one. The result is the percentage gain or loss during the computation period. With hedge funds, however, you have to take a number of other factors into account that can significantly affect the NAV, and hence, fund performance.
1. Adjust for liquidity. Some hedge funds routinely purchase securities that are not commonly traded in the open market. Since there is no fair market value price recorded regularly on the exchanges, it can sometimes be challenging to assign a fair market value to these securities. When this occurs, either the fund or a third party consultant will assign an estimated value to the security by substituting the value of a comparable security of similar financial and risk parameters for which they do have a recent market valuation. This is an inexact science, however.
2. Adjust for global markets. Domestic mutual funds calculate their NAVs as of the close of the trading day on the east coast of the U.S. However, securities are traded on exchanges all over the world, 24 hours per day. The fund company must come up with a uniform way to calculate fund NAVs using trading figures in overseas exchanges. For example, the fund company can use a NAV based on the last close in each market, or as of a certain time each day. The methodology should be included in the hedge fund prospectus.
3. Adjust for leverage. The assets under management in each fund can be significantly different from the NAV, because of the use of leverage. When a hedge fund borrows money, it increases assets under management, but NAV is roughly neutral in the short run, because every dollar borrowed adds to the portfolio but also adds to the liability column. However, in rising markets, leverage can help boost returns, though leverage also increases risk.
4. Adjust for fees. The hedge fund world has traditionally charged a "two and twenty" compensation scheme: The management company gets 2 percent of assets under management for operating expenses, plus an additional 20 percent of any investment gains. The performance as far as the investor is concerned is the net to the investor after any fees and expenses. This can be a substantial hurdle for fund managers to overcome, even with leverage.
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