Hedge fund reporting challenged

Investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment and whether this allocation yields positive returns or not. Information on past investment returns is of particular interest, as is information on prospects for future gains or losses.

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Unlike mutual funds, hedge funds are reluctant to provide detailed information on their investment portfolios. Since many hedge funds use highly speculative investment strategies, fund managers fear disclosure of their portfolio holdings would significantly decrease their chances of winning their bets and reduce investors' returns.

Incomplete disclosure can have some undesirable side effects. It might open the door for hedge fund managers to change their investment strategy or to include investments in the portfolio that are riskier than provided for by the managers' mandate. Investors even risk fraudulent behaviour, since the action of the hedge fund management might be detected only when a fund has failed.

The growth of the hedge fund industry over the past decade has aggravated the problem. In the past the typical hedge fund investor was a wealthy private client. More recently institutional investors have increased their stakes in hedge funds considerably.

Institutional investors like pension funds or insurance companies have more sophisticated investment objectives and require greater disclosure partly because they have to be accountable to their own investors.

Hedge fund reporting can be a source of tension between investors and hedge fund management. The objective of a recent EDHEC survey (EDHEC Hedge Fund Reporting Survey by F Goltz and D Schroder (2008), EDHEC Publication), which was carried out with the support of Newedge, was to shed light on current industry practices in order to establish an industry benchmark for hedge fund reporting in Europe.

To obtain a comprehensive view of industry practices, the EDHEC survey targeted the three main professional groups of the European hedge fund business: hedge fund managers; fund of hedge fund managers; and hedge fund investors. All were equally represented.

The survey participants were mainly medium-sized companies, with assets under management of between EUR100 million and EUR10 billion. However, some major companies with over EUR100 billion in assets under management also responded to the survey. About half of the 214 survey respondents are high-ranking executives (CEOs, managing directors, chief financial officers).

Quality of reporting reflects fund
One of the most important findings of the survey is that the hedge fund industry unambiguously believes a fund's reporting quality is an indicator of the overall excellence of a hedge fund. Furthermore, reporting quality is essential to an investor's decision to invest in a hedge fund. The study shows over 70% of all investors have internal disclosure requirements that must be met before they invest in a hedge fund.

Most practitioners think the main objective of hedge fund reporting is to assess the risk/return profile of the hedge fund under consideration. Risk information for the investors' total asset allocation and performance attribution are also considered important objectives of hedge fund disclosure.

Awareness of information needs
The EDHEC survey reveals hedge fund managers are not necessarily well informed of their investors' needs for information. In general investors consider much more information to be relevant to the risk assessment of a hedge fund than do the managers themselves.

Looking at the perceived importance of components of hedge fund disclosure by professional group, most differences are found in relation to information on liquidity risk, operational risk, and the portfolio composition of hedge funds (Figure 3). This implies that investors want to see much more disclosure on these issues than fund managers consider necessary.

Other differences are apparent when it comes to the qualitative outlook, risk-adjusted performance and the beta exposure of a fund. When the facets of risk and performance disclosure are compared, hedge fund managers think information on risk-adjusted returns is relatively more important to investors. However, investors themselves regard this aspect as least important. They stress the relevance of information on past returns and extreme risks.

Hedge fund managers use many risk and performance measures without disclosing them to investors, believing that their investors are uninterested in these additional indicators. Since hedge fund disclosure is designed to inform investors, this divergence in the views of what information is important is an obstacle to hedge fund investment.

Disclosure practices
As a direct consequence of scarce information, current hedge fund reports do not satisfy the informational requirements of investors. Although hedge fund reports are perceived to provide consistent, clear and sufficiently frequent information on past returns, many crucial issues of hedge fund risk are left unaddressed.

Some of the perceived shortcomings of hedge fund disclosure are illustrated by opposing perceived importance with the perceived quality of aspects of hedge fund reporting (Figure 4). The scatter plot makes it possible to detect aspects of hedge fund reporting that are judged important but do not yet comply with the investors' requirements (upper left part of the plot).

These missing aspects include, most importantly, information on a fund's liquidity risk, operational risks and factor exposure. Other topics viewed as neglected in hedge fund reporting are information on leverage risk (53% of all responding investors are dissatisfied with leverage risk disclosure) and the valuation framework.

The survey also presents evidence that many hedge fund managers overestimate the reporting quality of their funds. Hedge fund managers view the information they disclose much more highly than do their investors (Figure 5).

The gap between managers' and investors' views of the quality of information on auditing and compliance with the fund's private placement memorandum (PPM) is particularly wide.

There are similarly divergent views on the quality of reporting in general. Whereas almost all investors consider the information contained in hedge funds is sufficient to assess the reporting quality, more than half the managers disagree. In contrast fund managers agree their information disclosure on issues concerning valuation, or internal controls is insufficient.

Performance indicators
The survey found that inappropriate performance measures prevail in the hedge fund industry. Some of these problems are summarised in the table below. Although many empirical studies present evidence that the Sharpe ratio, for example, is not suitable for risk-adjusted hedge fund returns, many respondents still believe in this measure.

Likewise, most of the funds that report factor exposure rely on standard linear factor models although empirical research has shown that non-linear factor exposures play an important role in hedge fund returns.

Many industry participants want to see a hedge fund's alpha calculated with respect to a hedge fund index or a peer group of hedge funds. However, these techniques are not appropriate as a benchmark or as a means of calculating a fund's abnormal return since they are too crude and thus do not reflect all risks related to hedge fund investment.

The smoothing of hedge fund returns as a result of illiquid assets is another critical point. Although academics have proposed adjustments to correct for overly smooth hedge fund returns, they are rarely used. Finally, a substantial fraction of survey respondents judge manager estimates to be a suitable way to price hard-to-value assets.

This practice, however, might induce managers to misstate the returns of their hedge funds deliberately. The hedge fund industry is still beset by many inappropriate reporting practices.

Implications
The results of the survey have a number of implications for the hedge fund industry. First, differences between hedge fund managers' perception of relevant information disclosure and their investors' needs suggest that the industry should expand overall disclosure.

Although there might be good reasons not to disclose the portfolio composition of hedge funds in great detail, many other aspects of risk reporting could be easily improved without putting a hedge fund's investment strategy in danger.

Second, hedge funds should move to more appropriate risk and performance measures when disclosing their returns to investors. A large body of academic literature shows that many prevailing risk measures are unsuitable for reporting the true economic risks of hedge fund investment.

The problem is not that there are no meaningful indicators, but that they are not actually used.

This article is based on an EDHEC Risk and Asset Management Research Centre programme on hedge funds, which is supported by Newedge.

David Schroder, PhD, business analyst, EDHEC Risk and Asset Management Research Centre

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