Another indicator of performance that is very popular for hedge funds is their alpha (i.e., alpha is a measure of absolute performance). Studies show that hedge funds usually have alphas that are too high when compared to the market efficiency hypothesis. However, the estimation of alpha is quite questionable.
First, it is a measure associated with a factor model, and the results may differ greatly from one model specification to another. Second, studies on hedge funds often neglect the specification errors related to the estimation of a model.
Neglecting these errors may greatly bias the estimation of alpha. Besides, the financial literature that ranks hedge funds on a risk-return basis resorts more to the indicators of downside risk, such as semivariance, semideviation, and shortfall risk measures.
The literature recently seems to be more concerned with fat-tail risk. Finally, many reports rank hedge fund by percentiles, which allows visualizing on a chart, the relative position of a hedge fund in its category.
Ranking has another meaning in finance. It refers to the status of a security issue of a company relative to another, such as debt. Debt may be subordinated or junior to another, which implies that in case of bankruptcy, the holders of senior debt will be repaid before the holders of junior or subordinated debt.
As suggested by Teweles and Bradley (1982), common stock may also be classified in the form of class A and class B shares. According to these authors, the difference in class A and class B stocks is generally voting rights: class A has voting rights and class B has no voting rights. However, there is no uniform format regarding this classification. the term “ranking” often appears in the prospectus of a security issue.
For instance, in the information statement of an issue of managed futures notes, prepared by the Business Development Bank of Canada, on December 2002, the following was noted in the ranking section: “The notes will rank pari passu, with any preference among themselves, with all other outstanding, direct, unsecured and unsubordinated obligations, present and future.” In its prospectus, a company must thus specify the legal priority of an issue over the former ones (BDC, 2002).