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Features
Alternative Investments - September 03, 2004

Fund of Hedge Fund Reporting

A Return-Based Approach to Fund of Hedge Fund Reporting

Following on from the Edhec European Alternative Multimanagement Practices Survey, Edhec has decided to set up a European consultation process for the improvement of fund of hedge fund reporting. This initiative is intended to be a response to criticism of the inappropriate content of the reports that are addressed to European investors, as highlighted by the Edhec European Alternative Multimanagement Practices Survey.

Initial results indicate that investors and FoHF managers agree on the most important issues:

  • FoHF activity reports can be published every month. For 67% of the respondents, all major issues in both the performance and risk dimensions could be accounted for in a report issued on a monthly basis.

  • FoHF activity reports should contain an in-depth analysis of the risk dimension: respectively 74% and 68% of the respondents consider that a style analysis and factor analysis should be included in the report, on top of traditional risk measures like volatility or drawdown measures.

  • FoHF activity reports must account for extreme risks: 49% and 43% of the respondents, respectively, consider that the report should include extreme risks measures such as the Modified VaR and the Beyond VaR. In this respect, 53% of them consider the Omega ratio to be an important or very important indicator. However, in line with the results obtained in the Edhec European Alternative Multimanagement Practices Survey, the Sharpe ratio remains the preferred risk-adjusted performance indicator, with 78% of the respondents considering it important or very important.

On the one hand, investors and FoHF managers seem to share the same views on FoHF reporting. On the other hand, investors and FoHF managers seem to be adapting their investment practices progressively to account for the specific risk features of alternative investments. The results are therefore very encouraging for the future.

Alternative investment has experienced a two-stage development process in the past fifty years. Initially, there was a long period of incubation, during which only a few wealthy private investors bought shares in hedge funds in a search for absolute performance. The bursting of the Internet bubble then broadened the range of subscribers. Since all investors were looking for investments that were liable to improve the diversification of their portfolio, they naturally turned to hedge funds. The massive arrival of institutional investors and the diversification of the risk profiles of final investors allowed an in-depth examination of the management practices in the alternative universe to take place, highlighting risk control in particular. The initial work that aimed to rationalise and, above all, to standardise these management practices, was carried out under the impetus of the Investor Risk Committee (IRC), set up by the International Association of Financial Engineers.

This work is all the more important in that the risk-taking and control that should result from it form, essentially, the basis of alternative investment. Even the so-called non-directional alternative strategies, i.e. those that are not directly subject to market risk, are exposed to multiple risk factors such as volatility risk, credit risk, liquidity risk, etc. (cf. Amenc et al. (2003)1). It is therefore true to say that correct assessment and rigorous monitoring of risks are requisite conditions for a hedge fund to function well. It is thus vital for investors to ensure that the funds in which they have invested or in which they wish to invest (again) have adequate control over the risks being run. However, in spite of this obvious fact, investors are rarely in a position to implement satisfactory risk monitoring and control. The main reason put forward relates to the low level of information generally provided by hedge funds. A study carried out recently by Edhec involving 61 European multimanagers (cf. Edhec (2003)2) shows that, while 84% of the firms questioned include a volatility calculation in their monthly activity report (69% also include a Sharpe ratio, 22% a Sortino ratio and 20% a Value-at-Risk calculation), none provides a truly robust measure of the extreme risks, even though this is a measure that represents an element of information that is capital for all investors. (See graph 1)


Besides, the inadequacies of the monthly activity reports published by funds of hedge funds (hereafter FoHF in the text) do not stop there. Numerous studies have posed the question of the relative performance of hedge funds compared to traditional asset classes. Many have concluded that there was conditional and unconditional outperformance from strategies, thereby feeding the myth of “absolute return strategies.” On the basis of this observation, researchers and investors have tried to highlight the eventual persistence of hedge fund performance so as to justify the usefulness of stock picking. Paradoxically, the results obtained are largely favourable for the allocation and risk management process. While no study has been able to produce tangible proof with regard to the persistence of hedge fund performance beyond a 6-month horizon, some have underlined the stability of the funds’ risk profile (cf. Kat and Menexe (2003)3 or Mozes and Herzberg (2003)4), thereby justifying the investors’ transfer of interest from the alphas (i.e. absolute performance logic) to the betas (i.e. diversification logic) of alternative strategies. To adapt to this evolution, multimanagers have offered investors FoHF that are specialised by strategy and FoHF that provide particular diversification objectives. Unfortunately, the reporting from these FoHF has not satisfied the new needs of investors. None of the respondents to the Edhec survey (2003)5 provides, for example, the exposure of their funds to the principal risk factors. This is obviously in total contradiction with the fact that 95% of the FoHF consider that the quality of reporting and of risk control is the second most important criterion when they select a fund (with the most important criterion being the coherence and the quality of the explanations given by the managers on the subject of their investment strategy). (See graphs 2 & 3)




The objective of the discussion paper was to contribute to the debate on the relevant information to transmit to investors that hold shares in FoHF. As such, it provided a recapitulative list of the figures that it would be desirable to include in the reports sent out to investors by the FoHF, in conformity with the recommendations of the IRC, and more particularly with those presented by the working group responsible for examining the specific problems posed by FoHF (cf. Minimum Transparency Requirements for Fund-of- Hedge Funds - IRC Meeting Findings Amsterdam, June 2002, Hedge Fund Disclosure for Institutional Investors, July 2001). We also provide, in light of recent research on the theme of evaluating the performance and risk factors of hedge funds, a series of indicators that are appropriate for the specific characteristics of alternative strategies.

Notes:

  1. Amenc, N., Martellini, L. and Vaissié, M., 2003, Benefits and Risks of Alternative Investment Strategies, Journal of Asset Management, Vol.4, N°2, p.96-118.
  2. Cf. Edhec European Alternative Multimanagement Practices Survey, 2003
  3. Kat, H. and Menexe, F., 2003, Persistence in Hedge Fund Performance: The True Value of Track Record, Journal of Alternative Investments, Spring 2003, Vol.5, N°4, p.66-72
  4. Mozes, H. A. and Herzberg, M., 2003, The Persistence of Hedge Fund Risk: Evidence and Implications for Investors, Journal of Alternative Investments, Fall 2003, Vol.6, N°2, p.22-42