How Much Transparency Do Hedge Funds Need?

Jun 26 2009 | 11:09am ET

By Aleksey Matiychenko and Gregory Dyra -- April and May have been tremendous months for global financial markets. MSCI World Index rose 11.49% and 9.52% respectively. While the index is currently down 83 basis points in June, it is up 7.46% for the year.  The world as a whole seemed to perform better than did U.S. While S&P rose 15.2% from March 31, 2009 through May 29, 2009, by June 22 the index was only up 2% for the year. Emerging markets, on the other hand, are now up more than 32% year to date.

It seems that hedge funds have been able to ride the up market well.  The Barclay Hedge Fund Index is now up more than 10% through the end of May with all hedge fund strategies posting positive performance.  Perhaps proving the existence of mean reversion, the biggest losers of 2008 posted the best performance in 2009 so far. Convertible Arbitrage Strategy that lost 27.66% in 2008 is up 19.18% through end of May. While the Emerging markets strategy lost 39.57% in 2008, it is now up 21.29% year to date.

While the hedge fund industry has shown signs of recovery, there has not been a tremendous increase in the launching of new funds.  Based on the Barclays database we estimate that about 40 funds have been launched so far this year. This figure is even exaggerated since it includes multiple share classes of some of the funds. In comparison more than 1,900 funds were launched in the first five months of 2008. As of June 6, 2009 about 300 funds have not reported performance for April 2009.

While some reports suggest that the outflow of capital from the hedge fund industry has slowed, the industry remains in a transitional or rather transformational stage.  In the post Madoff world, the days of happy, trusting Goldilocks approach to picking hedge fund managers are over. The Madoff case served as a catalyst to shift investors’ views on how to select, evaluate and invest in hedge fund managers. The initial kneejerk reaction promoted conversations of investing only in fully transparent and liquid hedge funds via Managed Account structure. While it’s unlikely that hedge fund industry will shift entirely into Managed Account structure, it’s clear that hedge funds that want to survive in the new world will need to adjust to tougher demands from their investors.

The three most popular demands that are likely to be imposed on surviving funds are lower fees, better liquidity and better (full) transparency.

In this column, we briefly touch on the first two and discuss the last one in more detail.

Fees

Hedge fund managers typically make money from a combination of the management and performance fees. Most funds have High Water Mark provisions that imply that the funds cannot charge performance fees after suffering losses until those losses are recouped by the investor. After suffering the worst year in 2008, most hedge funds are not likely to collect performance fees in 2009. It’s likely that the standard “2 & 20” model will change in the future, though, it’s unlikely that the fees will fall significantly as they will become even more essential for covering funds’ operating expenses.

Liquidity

Liquidity, or rather lack of it, can be blamed for many problems related to the current crisis. Anecdotally we have seen the trend in launches of more liquid fund of funds products. Managed accounts with weekly or daily liquidity seem to be in fashion for now. The liquid/managed account structure has certain advantages since it provides investors with transparency, liquidity and control of their portfolios. Not all hedge fund strategies, however, lend themselves to such structure. It seems unlikely that the hedge fund industry will shrink down to just Equity Long/Short, Equity Market Neutral and CTA strategies (the strategies that are most suitable for the managed account structure).

Transparency

Perhaps one of the biggest complaints about hedge funds is the lack of transparency. The press and the media describe hedge funds as opaque investment vehicles striving on secrecy and open only to the rich. Many investors blame that alleged opaqueness for many of the financial problems that we are experiencing right now. Some demand full transparency.

While some of the criticism is valid, it would not be fair to just say that all hedge funds are secretive and opaque. In this article we touch on three main topics related to transparency: the current state of hedge fund transparency, pros and (mostly) cons of full transparency, and our own view.

Current State of Hedge Fund Transparency

Hedge Fund transparency in the current state ranges from the Black Box Model on one side to the Full Transparency model on the other side. The most secretive funds provide their investors with monthly return and general leverage information. The leverage information is typically provided in the form of percent of equity allocated to long and short positions. These funds may disclose more information in due diligence meetings and conference calls, but most often will not report this information in the printed form.  The funds that report full transparency may provide investors with full position data on either real (or close to real) time basis or on a lagged basis. Most hedge funds regardless of the transparency model usually provide their investors with monthly and quarterly letters.

While the content and quality of these letters differ widely, we found that there are certain commonalities among hedge funds in different strategies. For example, the majority of Equity Long/Short hedge funds report Industry and geographic allocations. Many report concentration and maybe even the names of the top five positions. Fixed Income Arbitrage funds often report their interest rate exposure by currency and maturity buckets.

While a diligent investor may be able to collect many pieces of the available transparency data, the absence of any standards in reporting this data makes it extremely difficult to use it on a consistent basis.

Full Transparency

There have been many calls for requiring hedge funds to provide full transparency. The hedge funds’ rebuttal that those calls are no more legitimate than calls to require Coca Cola to disclose its secret formula is valid in its own right. There is an even stronger argument against full transparency. It will likely do more harm than good for the investor.

Hedge funds invest in a variety of financial instruments that range from plain vanilla stocks and bonds to complex derivative instruments. Most hedge fund investors do not have the necessary systems, budgets, or the time to be able to take every position reported by every hedge fund in their portfolio and perform a meaningful analysis. There are, of course, software solutions that are available on the market that may be able to handle many of the instruments, but the cost and complexity of these solutions in the constrained budget environment may not be justified by the value added.

Obtaining full transparency and failing to analyze it may result in two problems for the investor.

  1. After obtaining position data from the fund, the investor may experience a false sense of security and become complacent when analyzing the fund. Full transparency may justify putting a checkmark in a due diligence questionnaire, but may not result in any actionable steps.
  2. The second problem may exist for the fund of funds and other professional investors in that failing to perform an adequate analysis of position data may actually imply the failure of fiduciary duties with respect to their clients or share holders.

If full transparency is not appropriate, then the natural question to ask is: What level of transparency should investors demand?

Our View

Transparency reported by hedge fund managers should be reasonable, informative, useful and timely.

Reasonable

To be reasonable, the required transparency should have the following qualities:

  1. Reporting frequency should coincide with the fund’s liquidity. While it may be informative to know what the fund with quarterly liquidity is holding on a daily basis, it would not provide investors with any actionable steps, and would impose an undue burden on the manager.
  2. Reports produced by the manager should be consistent. An investor should be able to obtain reports in the same format and with the same content.
  3. Transparency should not be excessive. Managers should not be required to disclose their trade secrets. Conversely, investors should also be able to process reported information without undue burden and excessive costs.

Informative

Information provided by the fund should be both relevant to the manager’s strategy and comprehensive enough to be able to analyze the fund’s exposure. For Equity Long/Short hedge funds, an investor may want to collect Industry exposures, hedging positions, and top positions. For fixed income funds, an investor needs to collect the interest rate and credit sensitivities (in the form of DV01 and CDV01). Multi strategy funds may need to report a combination of the above.

Useful

There is no point in requesting transparency from hedge funds if the investor makes no use of it. Four types of analysis can be performed using the information collected from hedge funds.

  1. Historical Trends. While hedge fund positions may change on a daily or intra-day basis, the overall trend in exposures may provide information about the fund’s style (and potentially about any style drifts).
  2. Aggregate Analysis. Being able to collect data in a consistent form would allow investors to aggregate information across hedge funds in their portfolios and get a more complete picture of their investments.
  3. Monitoring. Industry exposure and top positions exposures may provide investors with a way to monitor and quickly identify the hedge funds which may be exposed to market news or events.
  4. Risk Analysis. Exposure data may be used to perform simulation analysis and estimate such risk analyses as Value at Risk, Drawdown Simulation, and Stress Tests. In the following section we describe the steps necessary for performing such analyses for an equity long/short hedge fund.

Timely

In order for information to be useful and actionable it needs to be delivered on a regular basic and in a timely fashion.  Many hedge funds currently file form 13F disclosures that contain information about their long equity holdings. While 13F information may be interesting it’s not timely since it’s delivered quarterly with a lag that may extend up to 45 days.  For hedge funds with moderate or high turnover in their portfolios such disclosure proves to be of limited use to investors.

Example:

Risk Analysis – Equity Long/Short Fund

An investor who has collected  building blocks for Industry exposures data from an Equity Long/Short hedge fund may use that information to estimate Value At Risk (VaR) using the Monte Carlo techniques. To do that the investor needs to perform the following steps:

  • Collect long/short exposure for each Industry
  • Make an assumption about correlation between long and short positions
  • Simulate results
  • Calculate VaR

Collect Long/Short Exposure

Investor can collect information about industry exposure from each Equity Long/Short hedge fund in the portfolio. Exposure information can be mapped into MSCI World or S&P GIC scheme. This would allow investors to assign traded benchmarks to represent each industry exposure. Traded industry indexes or ETFs can be used.
 

Make an Assumption About Correlation Between Long and Short Positions

An investor must decide whether to use Net or Gross exposure when performing simulations. The decision depends on the relationship between the long and short positions.

For the funds that use short positions as hedges for their long portfolios, net exposure may be an appropriate metric to use since the short positions are assumed to be highly correlated to long positions. For the funds that take directional bet on either long or short side, the gross exposure may be the more appropriate measure.

A more sophisticated model may make an assumption on the actual correlation between long and short positions.

Simulate Results

Historical track records of the proxy ETF, or indexes assigned in Step 1 may be used to estimate the covariance matrix and expected returns. The information then can be used to simulate performance on either a daily, weekly or monthly basis. Different models can be used to perform simulation. In the simplest form, the multi-variate normal distribution may be used to generate return data. Since normal distribution may not be appropriate for capturing tail behavior, different distributions (e.g. student-T, extreme value) may be used to simulate the return data. Copulas may be used to preserve the desired correlation structure.

Once the returns are simulated, Value at Risk as well as other risk statistics can be easily calculated by examining the properties of distribution of the generated returns.

Conclusion

We have presented our views on the appropriate use of hedge fund transparency as well as what level of it should be required from hedge fund managers. While we believe that full transparency should not be required and may actually be detrimental to investors, we support the effort to improve the reporting standards across the hedge fund industry.

Next Steps

Risk-AI, LLC aspires to transform the way risk and exposure information is reported and analyzed by coordinating an ongoing dialogue with a view to establish risk transparency reporting standards.  This dialogue ultimately must match the reporting needs of capital allocators with reasonable reporting capabilities of asset managers. Together with our partners at New Legacy Capital we are actively recruiting leading investment professionals across the industry and invite others to join our effort. We encourage both institutional investors and asset managers to contact us at transparency@risk-ai.com and look forward to reporting progress in the months ahead.

Aleksey Matiychenko, CFA, FRM, CAIA, is senior partner and CEO of Risk-AI, LLC. Gregory Dyra is a managing director at New Legacy Capital, LLC.


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