Risk-free rate as an appropriate risk measure in hedge fund performance evaluation

(Question)
Even in market neutral strategies, the risk-free rate may not be an appropriate measure of fund performance. Because:

A. the risk-free rate is not an appropriate risk measure because it ignores the systematic risk.
B. the risk-free rate is not an appropriate risk measure because the market neutral strategy does not always have a zero beta risk exposure.
C. the risk-free rate is not an appropriate risk measure because leverage in a market neutral strategy magnifies risk.


Answer: B

The risk-free rate argument rests on the assumption that a market-neutral strategy is risk-free due to zero beta exposure. However, even zero beta market-neutral hedge funds are not truly risk-free because there is no argument on what constitutes the "market."

Market-neutral strategies are often poorly diversified and hence may still contain significant unsystematic risk (not systematic risk).

Leverage magnifies risk in a fixed income arbitrage fund and not a market neutral fund.