An EDHEC Risk and Asset Management Research Centre Publication




                                    Hedge Fund Reportin...
Table of Contents

Foreword .................................................................................................
Hedge Fund Reporting Survey - November 2008




Foreword

Since it was set up in 2001, the EDHEC           findings on cur...
Hedge Fund Reporting Survey - November 2008




                                                 About the authors

      ...
Executive Summary




A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on ...
Hedge Fund Reporting Survey - November 2008




                                    Executive Summary


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Hedge Fund Reporting Survey - November 2008




Executive Summary


industry unambiguously believes that a                ...
Hedge Fund Reporting Survey - November 2008




                                    Executive Summary


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Hedge Fund Reporting Survey - November 2008




Executive Summary


private placement memorandum (PPM)                    ...
Hedge Fund Reporting Survey - November 2008




                                     Executive Summary


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Hedge Fund Reporting Survey - November 2008




Executive Summary


Conclusion
The results of this survey have a number of...
Hedge Fund Reporting Survey - November 2008




                                     Executive Summary




12   An EDHEC R...
1. Introduction




A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on   ...
Hedge Fund Reporting Survey - November 2008




                                     1. Introduction


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Hedge Fund Reporting Survey - November 2008




1. Introduction


government regulation, the reporting               of be...
Hedge Fund Reporting Survey - November 2008




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2. Background




An EDHEC Risk and Asset Management Research Centre Publication   17
Hedge Fund Reporting Survey - November 2008




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Hedge Fund Reporting Survey - November 2008




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Detailed reporting                              Examples o...
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Hedge Fund Reporting Survey

  1. 1. An EDHEC Risk and Asset Management Research Centre Publication Hedge Fund Reporting Survey November 2008 in association with
  2. 2. Table of Contents Foreword ............................................................................................................... 3 Executive Summary ............................................................................................. 5 1. Introduction ...................................................................................................13 2. Background .....................................................................................................17 2.1 Hedge Fund Reporting: Importance, Challenges, and Regulation ................................................................................................. 18 2.2 Performance and Performance Risk Measures of Hedge Funds ................................................................................................. 22 2.3 Specific Issues with Hedge Fund Performance ............................... 29 3. Methodology and Data ................................................................................35 3.1 Methodology ............................................................................................... 36 3.2 Data ................................................................................................................ 36 4. The View of the European Hedge Fund Industry on Current Disclosure Practices ................................................................39 4.1 Hedge Fund Reporting: the Big Picture ............................................ 40 4.2 Key Indicators: Performance Indicators and Risk Measures ........ 43 4.3 Specific Hedge Fund Risks Reconsidered .......................................... 48 5. Conclusion ......................................................................................................55 References ...........................................................................................................59 About the EDHEC Risk and Asset Management Research Centre .........66 About Newedge Global Prime Brokerage .................................................... 70 We are grateful to Stéphane Daul, Laurent Favre, Walter Géhin, Jean-René Giraud, Adina Grigoriu, Philippe Malaise, and Mathieu Vaissié for helpful comments. Any remaining errors are ours. Printed in France, November 2008. Copyright EDHEC 2008. The opinions expressed in this survey are those of the authors and do not necessarily reflect those of EDHEC Business School.
  3. 3. Hedge Fund Reporting Survey - November 2008 Foreword Since it was set up in 2001, the EDHEC findings on current industry practices and Risk and Asset Management Research on the preferences expressed by investors Centre has monitored practices in the and managers. Overall, the results suggest European asset management industry. that investors’ requirements for hedge The Centre’s surveys on the state of the fund disclosure diverge considerably both industry look specifically at the use of from hedge fund managers’ perception recent research advances and at best of what is relevant and from guidelines practices. These surveys have shed light and “best practices” published by industry on portfolio risk management, the use of bodies. In addition, today’s reporting still indices and benchmarks, funds of hedge relies heavily on risk and performance fund management, ETFs, alternative measures that the academic literature diversification, and real estate investment. has found unsuitable for hedge fund In particular, EDHEC published a report on portfolios. funds of hedge fund reporting practices in January 2005. In that document, we We are grateful to the many participants made the case that improved reporting who have responded to our questions would be useful to both investors and and without whom this survey would managers, and should not be seen only as not have been possible. We would also a constraint by the latter. like to express our appreciation to the authors of the survey, to Amélie Jean and The recent extraordinary events in Lucie Liversain, who helped distribute the financial markets are likely to increase questionnaire, and to the publishing team investors’ needs for proper information led by Laurent Ringelstein. disclosure. In particular, many hedge fund strategies have incurred significant losses, Finally, we would like to extend our raising awareness of their exposure to most sincere thanks to our partners various risk factors. Whether hedge fund at Newedge Prime Brokerage, whose managers should share information on generous support of our research into such risk exposures with their investors, information disclosure in the hedge fund and how they should do so, is, as it industry has enabled this survey to be happens, the focus of the EDHEC Hedge produced. We look forward to expanding Fund Reporting Survey 2008. This survey our research in this area with Newedge has enabled us to compare industry Prime Brokerage's backing in the months practices, guidelines issued by industry and years to come, so that EDHEC can bodies, and academic research into hedge continue to provide the industry with fund performance and risk disclosure. state-of-the-art applied research. The survey is divided into two parts. The first part outlines the issues with hedge fund reporting and gives a brief review of the state of the art in performance and Noël Amenc risk analysis for hedge fund investments. Professor of Finance Director of the EDHEC Risk and Asset Management The second part presents the survey’s Research Centre An EDHEC Risk and Asset Management Research Centre Publication 3
  4. 4. Hedge Fund Reporting Survey - November 2008 About the authors Felix Goltz is head of applied research at the EDHEC Risk and Asset Management Research Centre. He conducts research in empirical finance and asset allocation, with a focus on alternative investments and indexing strategies. His work has appeared in various international academic and practitioner journals and handbooks. He obtained a PhD in finance from the University of Nice Sophia- Antipolis after studying economics and business administration at the University of Bayreuth and EDHEC Business School. David Schroeder is a senior research engineer at the EDHEC Risk and Asset Management Research Centre. David obtained his PhD in economics from the University of Bonn. During his doctoral studies, he was also affiliated with the Centre de Recherche en Economie et Statistique (CREST) in Paris. His research focuses on empirical asset pricing, the predictive power of equity analysts’ forecasts, and decision making under ambiguity. He is a member of the Econometric Society and has presented at many international economic and finance conferences. 4 An EDHEC Risk and Asset Management Research Centre Publication
  5. 5. Executive Summary A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 5
  6. 6. Hedge Fund Reporting Survey - November 2008 Executive Summary Like any investors, investors in hedge funds establish an industry benchmark for hedge are naturally interested in knowing how fund reporting in Europe. hedge fund managers allocate their initial investment, and whether this allocation The EDHEC Hedge Fund Reporting yields positive returns or not. It is not only Survey is representative of the information on past investment returns that European hedge fund industry is of particular interest; prospects for future To obtain a comprehensive view of industry gains or losses are relevant to investors as practices, the EDHEC Hedge Fund Reporting well. Yet, unlike mutual funds, hedge funds Survey targets the three main professional are reluctant to provide detailed information groups of the European hedge fund business: on their investment portfolios. Since hedge fund managers, fund of hedge fund many hedge funds use highly speculative managers, and hedge fund investors, all investment strategies, fund managers fear of which are equally represented in the that a thorough disclosure of their portfolio survey. The survey participants are mainly holdings would significantly decrease their medium-sized companies, with assets chances of winning their bets, and thereby under management of between 100mn reduce investors' returns. But incomplete and 10bn EUR. However, some major disclosure can have some undesirable side firms with more than 100bn EUR in assets effects. It might open the door for hedge under management respond to the survey fund managers to change their investment as well. Moreover, about half of the 214 strategy or to include investments in the survey respondents are high-ranking portfolio that are riskier than provided executives (CEOs, managing directors, for by the managers' mandate. Investors CFOs). To shed light on hedge fund even risk fraudulent behaviour, since the reporting, the survey contains sections action of the hedge fund management devoted to issues of particular interest might be detected only when a fund has to hedge funds. Whereas the first failed. The remarkable rise of the hedge set of questions asks more general fund industry over the past decade has questions on the importance of aggravated the problem. In the past, and satisfaction with current hedge the typical hedge fund investor was a fund reporting, the other sections wealthy private client, but more recently address very specific topics, such as institutional investors have increased their appropriate performance measures, stakes in hedge funds considerably. These liquidity and leverage risk indicators, investors, such as pension funds or insurance or the difficulty of sensitive operational companies, have more sophisticated risk reporting. We present below the main investment objectives and therefore require results of this survey. greater disclosure, in part because they have to render accounts to their own investors. The quality of hedge fund reporting In this light, it is clear that hedge fund is an important indicator of a fund's reporting can be a source of tension between overall excellence and thus a crucial investors and hedge fund management. investment criterion The objective of this survey is to shed light One of the most important findings on current industry practices in order to of this survey is that the hedge fund 6 An EDHEC Risk and Asset Management Research Centre Publication
  7. 7. Hedge Fund Reporting Survey - November 2008 Executive Summary industry unambiguously believes that a objective of hedge fund reporting is to fund's reporting quality is an indicator of assess the risk/return profile of the hedge the overall excellence of a hedge fund. fund under consideration. Risk information Furthermore, we find that reporting quality for the investors' total asset allocation is essential for investors' decisions to invest and performance attribution are also in a hedge fund. In fact, this study shows considered important objectives of hedge that more than 70% of all investors have fund disclosure. internal disclosure requirements that must be met before they invest in a hedge Hedge fund managers are not aware fund. of their clients' true information requirements Is hedge fund reporting an important indicator for a hedge fund's overall quality? The EDHEC survey reveals that hedge fund managers are not well informed of their investors' needs for information. We find that, in general, investors consider much more information relevant to risk assessments of a hedge fund than do managers of the hedge funds themselves. The figure below illustrates these results by presenting the perceived importance of components of hedge fund disclosure by professional group. As can be seen, the perceived importance of information differs most about information on liquidity risk, operational risk, and the Objectives of hedge fund reporting portfolio composition of hedge funds, implying that investors wish to see much more disclosure on these issues than fund managers consider necessary. Other great 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 that information on risk-adjusted returns is relatively more important to investors. However, investors themselves regard this aspect as least important; they stress the Next, we examine what industry relevance of information on past returns practitioners believe to be the main and extreme risks. objectives of hedge fund reporting. Most practitioners think that the main An EDHEC Risk and Asset Management Research Centre Publication 7
  8. 8. Hedge Fund Reporting Survey - November 2008 Executive Summary What is important for a good hedge fund report? As a direct consequence of scarce Answers by professional group 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. The exhibit on the bottom of the opposite column illustrates some of the perceived shortcomings of hedge fund disclosure by opposing perceived importance with the perceived quality of aspects of hedge fund reporting. The scatter plot thus makes it Finally, we also find that hedge fund possible to detect aspects of hedge fund managers use many risk and performance reporting that are judged very important, measures without disclosing them to but that do not yet comply with the investors, believing that their investors are investors' requirements (upper left part uninterested in these additional indicators. of the plot). Since hedge fund disclosure is designed to inform investors, this divergence in the These missing aspects include—most views of what information is important is important—information on a fund's liquidity an obstacle to hedge fund investment. risk, operational risks, and factor exposure. Other topics viewed as neglected in hedge Current hedge fund disclosure fund reporting are information on leverage practices do not meet the demands risk (53% of all responding investors are of investors. dissatised with leverage risk disclosure), and the valuation framework. Hedge fund reporting—Wishes and reality Answers by fund of hedge fund managers and investors Hedge fund managers tend to overestimate the quality of their reporting The EDHEC hedge fund reporting survey also presents evidence that many hedge fund managers overestimate the reporting quality of their funds. As the exhibit below shows, hedge fund managers view the information they disclose much more highly than do their investors. The gap between the managers' and investors' views of the quality of information on auditing and compliance with the fund's 8 An EDHEC Risk and Asset Management Research Centre Publication
  9. 9. Hedge Fund Reporting Survey - November 2008 Executive Summary private placement memorandum (PPM) problems. Although many empirical studies is particularly wide. There are similarly present evidence that the Sharpe ratio, for divergent views on the quality of reporting example, is not suitable for risk-adjusted in general. Whereas almost all investors hedge fund returns, many respondents still consider the information contained in hedge believe in this measure. Likewise, most of funds is sufficient to assess the reporting the funds that report factor exposure rely quality, more than half the managers on standard linear factor models, though disagree. In contrast, fund managers agree empirical research has shown that non-linear that their information disclosure on issues factor exposures play an important role concerning valuation, or internal controls in hedge fund returns. In addition, many is insufficient. industry participants want to see a hedge fund's alpha calculated with respect to Does hedge fund reporting provide investors with sufficient information on…? Answers by group a hedge fund index or a peer group of hedge funds. However, these techniques are appropriate neither as benchmark nor 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 Inappropriate risk measures, performance hard-to-value assets. This practice, however, indicators and reporting practices prevail might induce managers to misstate the in the hedge fund industry returns of their hedge funds deliberately. We also find that inappropriate performance In short, the hedge fund industry is still measures prevail in the hedge fund industry. beset by many inappropriate reporting The table below summarises some of these practices. Overview: academic standards and current industry practices of hedge fund disclosure Academic Literature Industry practices Non-normality Hedge fund returns are not normally 62% do not know how to test for non- of hedge fund returns distributed (Agarwal and Naik, 2004) normality 68% prefer Sharpe ratio Dynamic factor exposure Linear factor models are not appropriate 78% use linear factor models of hedge funds (Fung and Hsieh, 1997) (Amenc et al., 2008) (Garcia and de los Rios, 2007) Alpha analysis Should be based on factor models; About 50% prefer peer group or HF index peer groups inappropriate (Sharpe, 1991) Smooth returns due to illiquid assets Hedge fund returns are smoother than Only 5% use return smoothing-robust they ought to be (Getmansky et al., 2004) measures An EDHEC Risk and Asset Management Research Centre Publication 9
  10. 10. Hedge Fund Reporting Survey - November 2008 Executive Summary Although guidelines and best and professional organisations (such as practices for hedge funds have a the Alternative Investment Management great impact on industry practices, Association, Hedge Fund Standards Board, they fall short of providing sufficient and others), our study finds remarkable guidance on disclosure for hedge shortcomings. Although these guidelines fund managers are the most important information source for the hedge fund industry (see the figure Information sources for good hedge fund reporting opposite), and thus have a great impact on the hedge fund industry, they rarely provide guidance on sound hedge fund disclosure. As the table below shows, many of these guidelines are very vague and cover topics where there is already standard disclosure, such as about the general hedge fund structure or information on past returns. Hence, these best practices fall short of encouraging hedge funds to provide information on very important aspects of hedge fund risks. Guidelines for disclosure of a fund's risk-adjusted returns, When comparing the information required extreme risks, leverage and liquidity risk, by investors with the guidelines and best or its factor exposure are given especially practices as issued by industry associations short shrift. Guidance of industry "best practices" on optimal disclosure of hedge funds Alternative Hedge Managed President's International Investment Fund Funds Working Organization Management Standards Association Group of Security Association Board (MFA) (PWG) Commissions (AIMA) (HFSB) (IOSCO) Reporting style (consistency, + + + o frequency, etc.) Valuation framework + + o o + Past returns o o + o Extreme risks o Factor exposure o Portfolio composition Leverage risk o o o Liquidity risk o + o Hedge fund structure o + + + (legal, management, etc.) Operational risk + + + o Topic mentioned in the guideline + Detailed advice in the guideline The upper panel contains the components of hedge fund reporting deemed to be very important by investors following the analysis presented in exhibits 8, 39, and 42 of this document, the lower panel those which are deemed less important. A circle (o) signifies that the respective guidance mentions the corresponding issue, a plus (+) indicates that it contains detailed advice for this kind of risk disclosure. Note that the report by IOSCO is meant to cover the valuation of hedge funds only. A more detailed discussion of these guidelines is contained in section 2.1. 10 An EDHEC Risk and Asset Management Research Centre Publication
  11. 11. Hedge Fund Reporting Survey - November 2008 Executive Summary Conclusion The results of this survey have a number of implications for the hedge fund industry. First, great 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, in great detail, the portfolio composition of hedge funds, many other aspects for 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. Finally, the evidence on hedge fund reporting practices suggests that current guidelines and best practices of industry associations are unlikely to boost hedge fund transparency, and thus investor confidence. Guidance on optimal disclosure of a fund's risk-adjusted returns, extreme risks, leverage and liquidity risk, or its factor exposure is often neglected. To ensure greater hedge fund transparency, existing guidelines should be extended to cover these risks as well. It is important to note that this statement should not be misinterpreted as a call for more regulation of the hedge fund industry. Nonetheless, better reporting is likely to benefit all those involved in the industry. An EDHEC Risk and Asset Management Research Centre Publication 11
  12. 12. Hedge Fund Reporting Survey - November 2008 Executive Summary 12 An EDHEC Risk and Asset Management Research Centre Publication
  13. 13. 1. Introduction A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 13
  14. 14. Hedge Fund Reporting Survey - November 2008 1. Introduction Like any investors, investors in hedge funds problem. In the past, the typical hedge are naturally interested in knowing how fund investor was a wealthy private client, hedge fund managers allocate their initial but more recently institutional investors investment, and whether this allocation have increased their stakes in hedge funds yields positive returns or not. It is not only considerably. These investors, such as pension information on past investment returns that funds or insurance companies, have more is of particular interest; prospects for future sophisticated investment objectives and gains or losses are relevant to investors therefore require greater disclosure, in part as well. Yet, unlike mutual funds, hedge because they have to render an account to funds are reluctant to provide detailed their own investors. Although recent years information on their investment portfolios. have seen attempts to create standards for Since many hedge funds use speculative voluntary hedge fund reporting, there is as investment strategies such as short selling, yet no industry agreement on hedge fund fund managers fear that a thorough disclosure. The objective of this survey is disclosure of their portfolio holdings would then to describe current industry practices significantly decrease the chances of to establish a European benchmark for winning their bets, and thereby reduce hedge fund reporting. 1 - The disclosure of short positions can lead the investors' returns.1 But incomplete to dangerous counter- disclosure can have some undesirable side A substantiated view on the multiple facets strategies by competitors; see Brunnermeier and Pedersen effects. It might open the door for hedge of hedge fund reporting is essential to (2005). Regulators such as the SEC largely agree on this fund managers to change their investment a better understanding of the conflicts view (Cox, 2006), adding that strategy or to include investments in the between hedge fund managers and their such disclosure could harm market efficiency. portfolio that are riskier than provided for investors. Only by detecting differences in by the managers' mandate. Investors even the perception of hedge fund reporting on risk fraudulent behaviour, since the action both sides of the equation, as it were, is it of the hedge fund management might be possible to surmount the existing barriers detected only when a fund has failed. to hedge fund investment. Moreover, this survey aims to compare the status quo of In this light, it is clear that hedge fund hedge fund reporting with recent academic reporting can be a source of tension between advances in the literature. The past ten investors and hedge fund management. In years have seen a tremendous increase in many economic frameworks, such conflicts the number of hedge fund performance of interest are solved by government and risk measures. Many of these new regulation, as is the case for standard indicators have their strong points, but mutual funds, which are subject to detailed have also created confusion about the disclosure rules. However, these rules do measures that should actually be used not apply to hedge funds. In essence, the for hedge fund disclosure. It is our aim hedge fund industry is not regulated, and to bridge the gap between the theoretical consequently hedge fund reporting is not arguments of financial economists and subject to legislative rules, leaving the the needs of the practitioners. Finally, the conflict with the investors and managers. The results of this survey might serve as an remarkable rise of the hedge fund industry industry benchmark for current reporting over the past decade has aggravated the standards. After all, in the absence of 14 An EDHEC Risk and Asset Management Research Centre Publication
  15. 15. Hedge Fund Reporting Survey - November 2008 1. Introduction government regulation, the reporting of best practices are very influential for quality of one's competitors can serve as a practitioners' opinions of optimal hedge standard. Similarly, investors tend to ask for fund disclosure. About two-thirds mention the same information. Hence, it is our hope these documents as the most important that this study can be useful for all industry information source. This study also reveals participants as a source of information that inappropriate performance measures on appropriate hedge fund disclosure. predominate in the hedge fund industry. Although many empirical studies have The EDHEC Hedge Fund Reporting Survey shown that the Sharpe ratio, for example, was taken with the help of an online is unsuitable for reporting risk-adjusted questionnaire sent to European hedge fund returns (Lo, 2002), many professionals in the hedge fund industry. respondents still trust it. Likewise, most For a comprehensive view on current funds that indicate their factor exposure practices in the industry, the survey targets to investors rely on standard linear factor the three main professional groups of models, though empirical research has the hedge fund business: hedge fund shown that non-linear factor exposures play managers, fund of hedge fund managers, and an important role in hedge fund returns hedge fund investors. To shed light on hedge (Fung and Hsieh, 1997, 2000). Finally, fund reporting, the questionnaire contained the survey shows that managers and sections devoted to issues of particular investors have diverging views on interest to hedge funds. Whereas the first the quality of current hedge fund section asked more general questions on reporting, their objectives and important the importance of and satisfaction with components. Not surprisingly, hedge current hedge fund reporting, the other fund managers have rosier views of the sections addressed very specific topics, quality of the information they disclose such as appropriate performance measures, than do their investors. Fund managers, for liquidity and leverage risk indicators, or example, believe that risk-adjusted returns the difficulty of sensitive operational risk are the most crucial performance measure. reporting. Investors, however, consider information on extreme risks far more important. Finally, We find that hedge fund reporting is hedge fund managers think that hedge fund primordial. 92% of all industry practitioners reporting is important to advertise their believe that the quality of hedge fund funds or to act as a fund selection tool for reporting is an important signal of a investors. Investors, however, stress that fund's overall quality, and thus pivotal hedge fund disclosure also helps to control for investors' decisions about hedge fund the fund managers' behaviour. investment. However, information disclosure is not viewed as adequate by investors. This survey proceeds as follows. Section Although they are satisfied with the 2 first discusses the importance of hedge information on past hedge fund returns, fund reporting in more detail and provides the information on their fund's liquidity a short overview of the existing regulatory and operational risk exposure is regarded as framework and reporting guidelines as incomplete. Industry guidelines and codes issued by government working groups or An EDHEC Risk and Asset Management Research Centre Publication 15
  16. 16. Hedge Fund Reporting Survey - November 2008 1. Introduction industry associations. We then summarise the most important risk and performance measures and discuss other crucial risks hedge funds are generally exposed to. The survey methodology is presented in section 3. The results of the EDHEC Hedge Fund Reporting Survey are found in section 4, where we draw a comprehensive picture of the status quo of hedge fund reporting. Section 5 draws conclusions from the survey results. 16 An EDHEC Risk and Asset Management Research Centre Publication
  17. 17. 2. Background An EDHEC Risk and Asset Management Research Centre Publication 17
  18. 18. Hedge Fund Reporting Survey - November 2008 2. Background Unlike mutual funds, hedge funds use 2.1 Hedge Fund Reporting: dynamic investment strategies and enjoy Importance, Challenges, and a high degree of freedom with respect Regulation to the instruments that they can hold in their portfolios. In addition, they can 2.1.1 Motivation and challenges of engage in short selling of securities and hedge fund reporting use leverage. Consequently, alternative In an illustrative example, Foster and strategies are infinitely more complex Young (2008b) show why detailed hedge than those of traditional funds. The fund reporting is indispensable—and complexity of hedge fund investments difficult to achieve at the same time. poses a challenge for analysis as They consider a hedge fund manager required by adequate and comprehensive who sells options that pay their holders a disclosure of returns. Although some of specific amount of money in the event of the key elements of hedge fund reporting a rare event.2 Then he invests the money can—in principle—easily be captured by obtained from selling the options and the appropriate indicators, others are of a collected hedge fund capital in treasury much more qualitative nature and thus bonds—and does nothing. If he is lucky, 2 - Such an event can be a decline of the S&P500 by harder to formalise. This section serves the rare event does not occur over the more than 20% in one year. as theoretical background to the EDHEC lifetime of the option, and consequently Hedge Fund Reporting Survey. We outline his fund will yield a rather high rate the major challenges for hedge fund of return—obtained from selling the reporting and review the tools available options and the interest gained on the to report performance and the risks of proceeds. In contrast, if the rare event hedge fund investments. occurs, investors incur a heavy loss. This hypothetical example makes clear why First, section 2.1 demonstrates both the good hedge fund reporting is difficult: importance and the challenges of hedge the mere disclosure of past returns may fund reporting, the existing regulatory not be sufficient to reflect the underlying framework, as well as guidelines and best risk of a portfolio. In addition, even the practices issued by government working more detailed risk reporting might not groups and industry associations. Section be helpful for investors: managers can 2.2 takes a closer look at the performance in principle just add some noise trading and risk measures used in hedge fund to their major investment strategy to reporting. Although some of the standard disguise the underlying bets. measures are widely used, they are not always suitable from a theoretical The example raises the question of standpoint. Finally, section 2.3 examines the possible means of increasing the specific issues that are of particular confidence of hedge fund investors. importance for hedge fund disclosure, In the remainder of this section, we such as leverage, liquidity, and operational describe some of the means of reducing risk. informational asymmetries between investors and hedge fund managers. 18 An EDHEC Risk and Asset Management Research Centre Publication
  19. 19. Hedge Fund Reporting Survey - November 2008 2. Background Detailed reporting Examples of such techniques are provided The most important means of reducing by Goetzmann et al. (2007); empirical asymmetries of information between evidence is provided by Bollen and Pool hedge fund management and investors (2007). Reported returns of hedge funds is detailed, consistent, and accurate are often much smoother than their true hedge fund reporting. When key figures returns. Thus, smooth returns may be a sign about past hedge fund performance, that a manager is gaming performance also called return-based reporting, are measures. This issue is discussed in provided, investors have a comprehensive more detail in section 2.3.2. Although picture of the past risks and returns of Goetzmann et al. (2007) also propose their stakes. A comprehensive description performance measures that are of the most important performance manipulation-proof, they are rarely used. and risk indicators is provided below A potential solution to the problems (section 2.2). However, even very detailed related to the disclosure of past returns reporting cannot entirely resolve the is so-called holdings-based reporting. problems of hedge fund opaqueness. Unlike return-based reporting, holdings- First, return-based hedge fund reporting based reporting attempts to disclose the is only backward looking. All information current holdings of hedge funds—which contained in hedge fund reports therefore might, however, generate managerial contains valuable prospective information opposition. We return to this reporting only when it is assumed that the future style in section 2.3.3. investment strategy and the investment environment will remain unchanged. The Auditing and external platforms rapidly changing strategies of hedge fund Another means of building trust between managers and occurrences of spectacular hedge funds and their investors is to hedge fund closures following sudden include independent third parties in changes in the markets prove that these the reporting process. Bringing in such assumptions are often untenable (even outside parties to validate the reported if the manager has positive intentions). figures can take place at different stages. Another problem is the abundance of the One possibility is to run the hedge fund proposed performance and risk measures. via a managed account which then carries Academics constantly propose new out the trading activity as directed by indicators, thereby improving and the hedge fund manager. The managed complicating things at the same time. Eling account platform can thus provide and Schumacher (2007) argue that many investors with the required information. of the proposed performance measures Another option is to rely on external lead to highly correlated rankings of platforms not to manage the hedge fund hedge funds. On the other hand, Do et al. itself, but merely to calculate the risk (2005) point out that traditional measures, and performance measures of the fund, such as the Sharpe ratio, can be very which can then be forwarded to investors. misleading when evaluating hedge funds. Finally, a hedge fund can decide to let its Next, many of the hedge fund performance reports be audited by a third party. Besides measures can be gamed by managers. these external devices, hedge funds can An EDHEC Risk and Asset Management Research Centre Publication 19
  20. 20. Hedge Fund Reporting Survey - November 2008 2. Background also opt to implement internal controls, fraudulent manager of the introductory such as delegating the determination of a example). Hence, unskilled managers may funds' net asset value to an independent successfully mimic the behaviour of good administrator, to achieve greater reporting managers over a certain time period and transparency. Since the involvement of thus earn high fees, without delivering third parties is seen as a very important any investment skill. In the light of the step to reduce operational risk, we come impossibility theorem, the fee structure of back to this issue in section 2.3.6. hedge funds does not seem to be a feasible means of increasing investor confidence. The involvement of third parties or internal controls is, however, no guarantee To sum up, despite the many cited of the correctness of a report—it is only a problems and caveats, hedge fund step in that direction. As with any third reporting remains the only sensible way party audit, there are conflicts of interest to reduce information asymmetries and between hedge funds and the auditing thus to create investor condence. Any firm, which can lead to suboptimal audit hedge fund reporting system will have its quality. Another drawback of hedge fund drawbacks, but detailed information on auditing is the great expertise required the hedge fund performance audited by of auditing firms. Since the investment an independent third party seems to be a strategies used by hedge fund managers reasonable solution for investors. Finally, evolve very quickly, auditing sometimes regulators or industry associations can has trouble in keeping up. Nevertheless, play a role in creating generally accepted auditing seems to have some positive reporting standards. We turn to this issue effects on reporting quality. Liang (2003) in the following sections. shows that audited funds have more coherent data in hedge fund databases, 2.1.2 Existing regulation of hedge which can be interpreted as a sign of fund disclosure greater reporting reliability. Although hedge fund disclosure is largely unregulated, hedge funds are subject Hedge fund fee structure to government regulations in many The complex fee structure of hedge funds, countries. Hedge funds that are registered with high performance fees and high in the US must comply with the country's water marks, might lead to the conclusion generally accepted accounting principles that hedge fund managers' fee structures (US GAAP). Many of the standards are are designed to align the interest of concerned with valuation principles and managers and investors. Unfortunately, thus do not affect hedge fund disclosure this is not so. Although fees mitigate itself (e.g., FASB 157). However, the FASB the conflict of interests to some extent, statement 107 (Disclosures about Fair Foster and Young (2008a) show that Values of Financial Instruments) imposes it is generally impossible to design an some regulations. In the UK, the FSA has incentive scheme that makes it possible decided to use a principle-based regulation to distinguish between skilled managers instead of creating rules that specify and unskilled managers (including the exactly what is permitted or prohibited. 20 An EDHEC Risk and Asset Management Research Centre Publication
  21. 21. Hedge Fund Reporting Survey - November 2008 2. Background Also, many regulations deal with aspects prevent further government regulation other than information disclosure. More of the industry and to make things more recent attempts to regulate hedge fund difficult for the industry's black sheep. disclosure in the US and the European Table 1 provides an overview of the most Union have failed.3 A detailed overview of important guidelines for hedge funds. hedge fund regulation in other European countries has been made available by the Many of the best practices are of a European Fund and Asset Management very general nature, and remain very Association (2005). undemanding. They do not spell out rules for hedge fund managers, but give 2.1.3 Reporting guidelines a rather broad overview of what the Besides existing government regulation, hedge fund management should do to there have been many attempts to impose improve the governance of a fund. The "best practices" or "sound guidelines" on sections on hedge fund disclosure are the hedge fund industry. Some of these particularly vague and deal mainly with attempts have been made by government the general set up of hedge funds, as organisations and financial authorities, displayed in table 2. Minimum compliance 3 - In 2004, the SEC designed a new rule that often with the aim of reducing systematic with such recommendations is unlikely would have required hedge risks in financial markets by encouraging to give substantial help to investors, as fund managers to register as investment advisors better hedge fund governance and Naik (2007) points out. Moreover, the and disclose many critical issues about hedge fund detailed hedge fund reporting standards. multitude of guidelines is a challenge governance. However, in In addition, associations of national hedge for hedge fund managers, since some of 2006, the US Court of Appeals overturned the rule. fund managers and industry initiatives the points addressed in the best practices In Europe, the European Commissioner for Internal have proposed best practice guidelines to might be in conflict with each other, Market and Services, Charlie McCreevy, rejected the Table 1: Best practices and guidelines for hedge funds European Parliament's 2008 attempts to increase hedge Date Region Name Organisation Content fund regulation in Europe, 2008 US Best Practices for the Hedge Fund Industry PWGa Overarching guidelines for asset arguing instead for Asset Managers' Committee managers self-regulation of the industry. 2008 US Best Practices for the Hedge Fund Industry PWG Overarching guidelines for hedge Investors' Committee fund investors 2007 US Sound Practices for Hedge Fund Managers MFAb Overarching guidelines for asset managers 2007 Europe Guide to Sound Practices for Hedge Fund AIMAc Overarching guidelines for asset Managers managers 2007 International Principles for the Valuation of Hedge Fund OICV-IOSCOd Hedge fund valuation Portfolios 2007 UK Guide to Sound Practices for Hedge Fund AIMA Hedge fund valuation Valuation 2008 UK 28 Best Practice Standards HFSB/HFWGe Overarching guidelines for asset managers Note that this list includes only the most important best practices and guidelines. Many other countries have their own guidelines, such as the AIMA Australia, or the FSA Dubai. In addition, there are other standards for risk management practices that are not specifically designed for hedge funds, such as those of the Risk Standards Working Group, the CFA, or the Investor Risk Committee. aPresident's Working Group on Financial Markets bManaged Funds Association cAlternative Investment Management Association dInternational Organization of Securities Commissions eHedge Fund Standards Board/Hedge Fund Working Group An EDHEC Risk and Asset Management Research Centre Publication 21
  22. 22. Hedge Fund Reporting Survey - November 2008 2. Background Table 2: Common standards for hedge fund disclosure Requirement Description/Example PPM Existence of a private placement memorandum Counterparties Disclosure of counterparties and third parties on request Strategy of the fund Style, permissible investment, use of leverage, regional exposure Key management Names and vita of the hedge fund management Conflicts of interest Managers running several hedge funds Conflicts between investors Disclosure on side letters and parallel managed accounts Legal framework Hedge fund structure, including fees and redemption rights Timely disclosure Disclosure of past hedge fund performance at regular intervals Valuation framework Detailed description of the valuation framework reflecting differences in market practices Clear rules for hedge fund disclosure, in the US and Europe. But most sets of either by government regulation or guidelines are similar, so compliance with by industry standards, can have many one set often implies compliance with the advantages. Investors are better informed, others.4 and more important, are equally well 4 - In October 2008, major informed—thereby eliminating the hedge fund organisations set up an internet site where Another difference between the various advantages privileged investors have at different guidelines can easily best practice standards is the enforcement the expense of others. Fund managers be compared. This overview is available at: www. of these standards. The newly issued best will appreciate a set of clear and simple hedgefundmatrix.com. practices of the Presidents Working Group rules that they can expect to satisfy (PWG) are completely voluntarily, the aim authorities and investors across the globe. being merely to create a benchmark for Likewise, regulators benefit from a unified hedge fund managers. The Hedge Fund disclosure framework, allowing them to Working Group's (HFWG) Best Standards, better assess the overall risks involved in by contrast, attempt to establish a "comply hedge fund investments. or explain" practice, meaning that non- complying funds are expected to explain why they are not doing so. However, it is 2.2 Performance and Performance not clear whether and how this practice Risk Measures of Hedge Funds could be enforced. Like any investor, the typical hedge fund investor is risk-averse, i.e., he has a The future is likely to see more guidelines preference for high returns, but dislikes on valuation and disclosure for hedge the risk related to his investment. All fund managers. Last year, the Global risk and performance risk measures thus Investment Performance Standards (GIPS) attempt to satisfy the investor's needs to announced that they would extend their be informed about the returns, but also framework to include hedge funds by about the related risks he bears. Some 2010. It is to be hoped that existing and measures, like return analysis, focus on new proposals will converge over time to the return component; others, such as an internationally accepted standard. extreme risk analysis, try to capture the riskiness of the hedge fund investment. 22 An EDHEC Risk and Asset Management Research Centre Publication
  23. 23. Hedge Fund Reporting Survey - November 2008 2. Background Finally, risk-adjusted performance measures currently used by hedge funds. measures and factor analysis combine Le Sourd (2007) reviews the measures both dimensions of any investment by aimed at traditional investment universes, relating return and risk to each other. but used by hedge funds as well. The literature on stocks and mutual 2.2.1 Analysis of hedge fund returns funds has proposed an abundance of An initial assessment of hedge fund measures that can be used to measure returns usually involves the analysis of the risk and return of these investments. past hedge fund returns using descriptive The crucial question is whether these statistics and statistical tests. Simple risk indicators can be similarly used to calculate, it is the basis of any hedge for hedge fund portfolios. The first fund reporting and is by far the most works to analyse hedge fund risk and informative to investors. performance, including the papers by Elton, et al . (1987), Brown, et al. (1999), Returns, return persistence, and and Ackermann, et al. (1999), draw on volatility these standard measures to determine Past hedge fund returns are without 5 - The calculation of past returns is not as simple as it whether hedge funds perform better doubt important information. Standard seems, since it is preceded by than the market or not. However, as presentations include monthly and annual the determination of the hedge funds' value, an subsequent works by Agarwal and Naik returns—net of fees—in absolute terms, issue which is tackled again in section 2.3.6. Moreover, (2000c), Fung and Hsieh (2001), Lo et al. and relative to a benchmark.5 Since there are several ways to (2001, 2002) have shown, hedge funds investors are less concerned with calculate the returns. For more detail, see chapter 2 of exhibit some particularities that make past returns than with future returns, Lhabitant (2004). them very different from standard equity persistence measures are important as investments. First, hedge fund returns— well. Gain frequency, calculated as the as opposed to mutual fund returns— percentage of positive monthly returns are not normally distributed. Second, is an initial indicator of performance they are non-linear with respect to the persistence. Closely related, but more standard market factors, such as equity complicated to calculate, is the Hurst and bond markets. Indeed, hedge funds (1951) coefficient. Finally, the volatility of often modify their investment style monthly returns is an initial assessment of so that their exposure to risk factors the riskiness of the hedge fund. Simpler, is highly dynamic over time. These but equally informative measures of a differences make the standard risk and hedge fund's volatility are minimum and return indicators—although still widely maximum past monthly returns, or—more used—inappropriate for hedge funds. generally—their upper and lower deciles (or quartiles). In this section, we briefly describe the most important performance and Downside risk performance risk indicators used in hedge There are also some key figures that help fund reporting. Lhabitant (2004), Amenc, to assess the downside risk of returns—an et al. (2005) and Géhin (2006) provide more issue of particular interest to hedge fund comprehensive surveys on most of the investors. The maximum past drawdown An EDHEC Risk and Asset Management Research Centre Publication 23
  24. 24. Hedge Fund Reporting Survey - November 2008 2. Background is a simple but informative indicator of measures underestimate a fund's riskiness. downside risk. The skewness and kurtosis It is therefore crucial to assess the hedge of fund returns are together important fund's risk of extremely negative returns. in assessing downside risk: a return distribution that is negatively skewed VaR and related measures. combined with positive (excess) kurtosis Value-at-Risk (VaR) is perhaps the most is a strong indicator of high downside important extreme risk measure. The VaR risk. Semi-deviation and other lower of a portfolio is the maximum amount of partial moments of hedge fund returns capital that can be expected to be lost are similarly useful. Finally, hedge fund within a specific time period (usually one returns during extremely negative equity month), given a specified confidence level markets are a good measure of a fund's (usually 95% or 99%). There are several ability to hedge downside stock market ways to calculate VaR. The simplest movements. is to assume a normal distribution of returns, which must be estimated to Non-normality and autocorrelation of calculate the expected maximum loss. hedge fund returns Since hedge fund returns are usually not Information can also be had by applying normally distributed, an alternative is to statistical tests to the hedge fund returns. use non-parametric estimation based on Statistical tests, such as the Jarque-Bera the historical distribution of hedge fund test (Jarque and Bera, 1980), make it returns. In this way, the non-normality is possible to assess the normality of hedge captured automatically. Another approach fund returns. If normality is rejected, the uses Monte-Carlo simulation techniques fund is likely to exhibit a larger downside to estimate the expected maximum loss. risk than standard equity investments. Such simulations can assume either Tests of autocorrelation, such as the normally distributed returns or more Ljung-Box test (Ljung and Box, 1978), are complex distributions that account for generally used to detect the fraction of the asymmetry and fat tails of hedge fund illiquid assets in the hedge fund portfolio. returns. If the test of no autocorrelation is rejected, the portfolio is likely to contain a large Besides the standard VaR, there are fraction of illiquid and thus hard-to- more sophisticated VaR measures that value assets. Consequently, return figures attempt to meet the needs of hedge fund must be treated with caution. Since both reporting. The so-called Cornish-Fisher issues are of special interest for hedge VaR (Favre and Ranaldo, 2002)—also called fund reporting, we come back to them in modified VaR (MVaR)—is an extension sections 2.3.1 and 2.3.2. of the standard VaR that incorporates the effect of skewness and the fat tails 2.2.2 Extreme risk measures of hedge fund returns. Incremental VaR Because of their non-normal return (Jorion, 2001) attempts to measure the structure and thus higher relatively change in VaR when a particular asset higher downside risk, simple volatility class is introduced to the portfolio. Closely 24 An EDHEC Risk and Asset Management Research Centre Publication
  25. 25. Hedge Fund Reporting Survey - November 2008 2. Background related, component VaR, described by leaving the rest unspecified. However, Jorion (2001), indicates the contribution since rare negative events are of great of a specific asset to the VaR of the overall importance for hedge funds, this tool portfolio. Conditional VaR (also called makes it possible to evaluate the risks expected shortfall) is another extension of related to such events. The distribution of the VaR approach. Compared to the VaR, the tail can then be used to estimate the it does not specify the maximum expected VaR. loss for a specific confidence level, but the average amount of loss if that significant Stress tests loss actually occurs. Conditional VaR is Besides the different VaR approaches, thus very important if the distribution of hedge funds often use stress tests to returns has very fat tails, since the loss assess extreme risks. Unlike the VaR, stress might be much larger than that specified testing requires no assumptions on a by VaR.6 Applications of the conditional fund's return probability distribution and VaR to hedge funds are by Agarwal and is therefore essentially a non-statistical Naik (2004) and De Souza and Gokcan risk measure. It relies instead on Monte- (2004). Finally, shortfall probability Carlo techniques to evaluate the impact 6 - Strictly speaking, conditional VaR and expected can be considered the inverse of VaR: of extreme but probable situations on shortfall are two different instead of estimating the maximum loss hedge fund performance. The crucial concepts. Conditional VaR calculates the expected given a confidence interval, the shortfall difference from VaR and EVT is the stress shortfall given a pre-specified condence level, whereas the probability indicates the probability that a test's ability to simulate shocks that have expected shortfall can also given loss will actually to occur. never occurred in the past, or which be calculated using another loss limit. are more likely to occur than historical 7 - See section 2.2.4 for more details on style analysis Another method of calculating a VaR evidence suggests. Stress tests can also be 8 - This is an important estimate relies on style analysis, the so- used to analyse the impact of structural difference to the general notion of liquidity risk, which called style VaR (Lhabitant 2001, 2004). shocks to the financial system on hedge usually denotes the liquidity risk within the hedge fund. This method first examines the fund returns. The basic idea of stress 9 - See Jorion (2001) for relationships of the investment styles in tests is simple: evaluating the impact of a detailed review of stress testing. the portfolio,7 then analyses the impact sudden changes in the determinants of of the worst variation of each style on hedge fund returns on their performance. the portfolio. Laporte (2003) proposes Such stress tests can simulate either the an extension of the style VaR to include consequences of changes in one particular liquidity risk borne by hedge fund key variable (also called sensitivity testing) investors through lock-up constraints.8 on hedge fund performance or the impact By adding an additional factor to the of an extreme variation in many critical style VaR, this model facilitates analysis factors (called multidimensional scenario of the impact of such clauses on a fund's analysis). Stress tests can simply assume VaR. Finally, it is important to mention a one-shot deviation from the variables the extreme value theory (EVT)(Embrecht under consideration or they can involve et al., 2008; Lhabitant, 2004). Actually, it more complicated models that reflect is not a variant of VaR, but an important the impact of so-called spiral effects tool to calculate it. EVT simply focuses on (second round effects) on hedge fund the modelling of the tails of a distribution, performance.9 An EDHEC Risk and Asset Management Research Centre Publication 25
  26. 26. Hedge Fund Reporting Survey - November 2008 2. Background 2.2.3 Risk-adjusted performance Modigliani and Modigliani (1997), also measures focuses on how to evaluate performance Sections 2.2.2 and 2.2.1 present measures compared to a benchmark. They suggest to analyse both hedge fund returns and adjusting the portfolio to have the same their related risks. The most interesting risk as the benchmark before comparing parts of hedge fund reporting, however, them. The M2 is hence equivalent to the are indicators that combine both analyses, return the fund would have achieved if it because above-average returns are not a had had the same risk as the benchmark, surprise when running high-risk strategies. often the market index. In essence, it The real challenge is to deliver good is equal to the Sharpe ratio times the performance while limiting risk exposure. standard deviation of the benchmark. Risk-adjusted performance measures are Closely related to the Sharpe ratio is the designed to detect investments that have Treynor (1965) ratio, which divides the a good risk/return trade-off. expected excess return of a portfolio by its beta, where the beta is calculated on the Sharpe ratio and related measures. basis of the CAPM (Sharpe, 1964; Lintner, The Sharpe (1966) ratio is the most 1965). The advantage of the Treynor ratio famous measure of return to risk. It is is that it focuses only on the systematic the ratio of the portfolio's expected component of risk, not on total risk. Along excess return over the risk-free rate with the evolution of multi-factor models, E[rp] - rf and its standard deviation σp: such as the Fama and French (1992, 1993) three-factor model, a generalisation of (1) the Treynor ratio has been proposed, including the portfolio's sensitivities to The higher the Sharpe ratio, the better more than one factor (Hübner, 2005). the risk-return trade-off. Intuitively, it can be interpreted as a fund's excess Although the Sharpe ratio is easy to return per unit of risk. In fact, apart calculate and in widespread use, it is from slight modications, all risk-adjusted inappropriate for measuring hedge fund performance measures follow this performance, since it assumes normally principle by relating returns to units distributed fund returns—an assumption of risk. Almost three decades after the that rarely bears out. The Sortino ratio Sharpe ratio, Sharpe (1994) proposed a (Sortino and Price, 1994) offers a slightly generalisation of his original ratio, the so- different measure by replacing the called information ratio (IR). It is the ratio standard deviation with the downside of the portfolio's excess return over that deviation. Consequently, the Sortino ratio of another portfolio (usually a benchmark) is more appropriate for hedge funds. and the standard deviation of the return Another variant of the Sharpe ratio is the difference between both portfolios. Thus, modified Sharpe ratio, also called return it captures the fact that managers often over VaR, which has been proposed by try to outperform a benchmark, while Gregoriou and Gueyie (2003). The modified maintaining a low tracking error. The M2 Sharpe ratio replaces the standard measure, owing its name to the authors deviation in the denominator of the 26 An EDHEC Risk and Asset Management Research Centre Publication

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