occurred over any number of months. The units of return received per unit of risk are summarized by Sharpe ratio and return-to-drawdown ratio. Both are helpful in gauging whether the risk taken was adequately compensated, and are particularly useful when comparing funds. Beta to the S&P 500 and alpha are included to help evaluate whether the hedge fund added value beyond a passive investment in the equity market. In the case of this fund, the beta is negative, but so is the alpha. Since the S&P 500 has had negative returns over the period of measurement, the investor may decide that, despite the negative alpha, value was added by having a negative beta and positive returns. This highlights the fact that these quantitative measures need to be considered in the context of fund strategy and the market environment. A graph of cumulative returns is included to help visualize performance. More information and analysis may be collected to help assess the relative merits of the hedge fund's track record, including comparisons to other managers with similar strategies. Final Evaluation The final view on the hedge fund will combine inputs and insights gathered while researching the investment strategy, people, organization, and track record. The view should include an assessment of the fund's strengths and weaknesses as well as expectations for return. Importantly, expectations for worst-case loss need to be laid out prior to investing to help frame future monitoring of the manager. Anticipating a worst-case loss of 5 percent from a hedge fund that is expected to deliver 20 percent net returns per year does not seem reasonable, for example. Such expectations will ultimately lead to disappointment and high turnover in the portfolio of hedge funds. Expectations for potential positive returns should also be specified, since unexpectedly large positive or negative returns may be an indication the manager is taking unanticipated risks. PORTFOLIO CONSTRUCTION Creating a portfolio of hedge funds needs to begin with a clear understanding of the investor's objectives and the fit of the hedge fund portfolio into his or her overall portfolio. The goal is to set a risk budget consistent with these objectives, and then allocate the budget to a portfolio of managers that are most likely to deliver returns that fulfill the objectives. In addition to expectations for return and volatility, investors should understand how large a loss they are comfortable sustaining in their hedge fund portfolio, as well as their liquidity requirements. These goals will help derive a strategic allocation to the various hedge fund sectors. Diversification at the sector level is an important source of risk reduction, so all four sectors should at least be considered in portfolio allocations. Table 27.1 shows correlation, risk, and return of the four hedge fund sectors defined previously, as well as for the equal-risk allocation discussed in Chapter 26. Correlations and beta to the S&P 500 are also presented. Correlations range from as low as 0.08