Hedge funds

Improving disclosure

How much should hedge funds, which depend on secretive risk-taking strategies for success, reveal to their investors? Deutsche Bank’s Maarten Nederlof and The Caxton Corporation’s Tanya Styblo Beder co-chair the Investor Risk Committee of the International Association of Financial Engineers, which focuses on the topic. Here’s what they proposed

The Investor Risk Committee (IRC) was launched in January 2000 with the specific task of discussing the right level of disclosure by alternative asset managers. It was felt by professionals at the New York-based International Association of Financial Engineers (IAFE) that, with investors now making up about 20% of all hedge fund assets, and with that percentage growing, that this was a pressing topic for the investment management community.

Over the past 10 months, four separate forums have been held by the group, and more than 100 firms have joined in the IRC’s work to date. The discussion has focused on investments by institutional investors in hedge funds.

The IRC primarily consists of individuals from hedge fund investment managers – “managers” – and professionals from a variety of institutional investors including pension funds, endowments, foundations, insurance companies, fund of funds and others, or “investors”.

The result of the IRC’s work is a set of findings that can be used by investors and managers to benchmark their practices relative to their peers. After very lively initial debate at the IAFE conference held in New York in October, members of the IRC quickly reached consensus on a number of critical issues.

This document sets forth the IRC’s findings. It is a starting point that the IRC hopes will enable greater participation by investors in this rapidly growing area.

For the purposes of this document, the IRC adopts the definition¹ of a hedge fund as “a pooled investment vehicle that is privately organised, administered by a professional investment management firm…and not widely available to the public.” As such, a wide variety of investment vehicles are included in this definition: small and large – in assets or staff; operating in one market or many; following a single, simple strategy or a combination of complex strategies; and operating onshore or offshore under varying organisational structures.

Findings
The IRC believes that investors have three primary objectives in seeking disclosure from managers. They are:

• Risk monitoring. It is important to ensure that managers are not taking on risks beyond represented levels in terms of allowable investments, exposures, leverage, etc.

• Risk aggregation. Investors should be able to aggregate risks across their entire investment programme in order to understand portfolio level implications.

• Strategy drift monitoring. Investors should be able to determine whether a manager is adhering to the stated investment strategy or style.

At the same time, the IRC agrees that full position disclosure by managers does not always allow them to achieve their monitoring objectives, and may compromise a hedge fund’s ability to execute its investment strategy. Therefore, despite the fact that many investors receive full position disclosure for many of their investments, the 100 members of the IRC who have participated in the meetings to date are in agreement that full position disclosure by managers is not a workable solution.

In particular, managers expressed significant concerns over the harm that full position disclosure could cause for many common hedge fund strategies. For example, macro investment and risk arbitrage techniques depend on secrecy in order to be successful. In a macro strategy, a manager might have one or two large positions in the currency, interest rate, commodity or equity markets. Furthermore, the manager might plan to hold on to the positions for several months. Hence, disclosure of these positions would place the manager in a position of jeopardy – others would be able to line up positions against the manager and/or would have crucial knowledge to be able to trade against the manager’s position.

Investors agree that this would be detrimental. They do not wish to force any level of disclosure that might be adverse to the manager, and therefore to their investment.

In addition, many investors are concerned that receiving huge amounts of data from their managers would be too much to handle. For example, a long/short equities manager may have tens of thousands of positions at any point in time that add up to millions of positions over the course of a year. Receiving and managing vast quantities of data that needs to be combined and analysed is a large and expensive task that cannot be implemented easily.

As a result, IRC members agree that the reporting of summary risk, return and position information is a sufficient alternative to full position disclosure. Such summary information should be evaluated according to four criteria: content, granularity, frequency and delay.

• Content describes the quality and sufficiency of coverage of the manager’s activities. This dimension covers information about the risk, return and positions on an actual as well as on a stress-tested basis.

• Granularity describes the level of detail of report. Examples are net asset value (NAV) disclosure, disclosure of risk factors as in arbitrage pricing theory (APT²) or value-at-risk³, for example, disclosure of tracking error, or other risk and return measures at the portfolio level by region, by asset class, by duration or by significant holdings.

• Frequency describes how often the disclosure is made. High turnover trading strategies may require more frequent disclosure – for example, daily – than private or distressed-debt investment funds where monthly or quarterly disclosure is more appropriate.

• Delay describes how much of a time lag occurs between when the fund is in a certain condition and when that fact is disclosed to investors. A fund might agree to full or summary position disclosure, but only after the positions are no longer held.

IRC members also agree that usability of any alternative disclosure depends on sufficient understanding of the definitions, calculation methodologies, assumptions and data employed by the manager. This may be accomplished in various ways, including discussions between investors and managers; by the manager providing for adequate transparency of their process; or via independent verification.

Finally, IRC members should benchmark their practices relative to their peers.

The IRC agrees that a major challenge to peer group performance and risk comparisons as well as aggregation across managers is the use of various calculation methodologies, assumptions and data employed in the market-place. IRC members do not, however, feel that “one size fits all”, and feel that multiple peer groups may be relevant depending on the nature of the investor as well as the strategies employed by the manager.

Investors and managers believe that an industry effort should be made to improve the ability to conduct comparisons across managers as well as multi-manager portfolio analysis.

It should also be noted that IRC members do not believe detailed reporting is a substitute for initial and ongoing due diligence reviews, on-site visits and appropriate dialogue between investors and managers. The IRC also believes that market, credit, leverage, liquidity and operational risks are inter-related, so exposure to these risks in combination should be included in the dialogue between investors and managers.

Conclusion
Even though the IRC has come a long way through its discussions over this year alone, it is clear that there is still a substantial amount of work that needs to be done. The committee’s goal is ultimately to provide consensus – among a substantial group of managers and investors – regarding the right level of disclosure by hedge funds, so it invites all managers, investors and other interested parties to comment and assist the group in the evolution of this document.

In particular, the IRC is looking at developing an industry consensus on a generally accepted technique for mapping position data into risk factors and/or methodologies for calculation of risk statistics. It also plans to develop a questionnaire to be filled out by managers that will generate a scatter plot of current practices.

The committee also wants to develop a questionnaire for investors, which will address minimum standards for the evaluation of alternative asset managers.

Finally, the IRC plans to develop sample templates for disclosure within various strategy types, such as sample methods for bucketing managers into various strategy types.

The IAFE is a global organisation devoted to defining and fostering the profession of financial engineering. Collaboration and networking between academics and practitioners are major objectives of the IAFE. After spending almost a decade on its founding mission – to define and foster the emerging field of financial engineering – the Association is turning its focus towards the established sectors of the field and another of the IAFE’s missions – forums such as those held by the IRC on appropriate topics of interest.

In particular, we wish to promote informed exchanges among members to further understanding, share best practices and establish standards on pertinent aspects of technology, credit risk, the impact of wireless and e-commerce, legal, regulation, risk management, tax and accounting. The work of the IRC is part of this mission.

Tanya Styblo Beder is a managing director at The Caxton Corporation, an investment fund in New York. Maarten Nederlof is a managing director at Deutsche Bank in New York. They both sit on the board of directors at the IAFE. Mark Anson (CalPERS), Bill McCaukey (III Offshore Advisors), Bill Miller (Commonfund) and David Mordecai (AIG) are IRC steering group representatives