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Alternative Investments - March 08, 2005

Edhec Funds of Hedge Funds Reporting Survey

In 2004, Edhec launched an international consultation process on the implementation of a new framework for Funds of Hedge Funds reporting. This consultation process was based on a series of recommendations proposed by Edhec with regard to the academic state-of-the-art on risk measurement in the alternative universe. The results of this consultation were presented to a panel of journalists on February 17th in London at a meeting hosted by FIMAT.

The development of alternative investment has not yet been accompanied by a genuine consideration of the specific characteristics of the risks and returns of hedge funds with regard to the provision of information to investors. This inadequacy clearly came to light in a study published by Edhec in 2003 which showed that a very large majority of European hedge fund managers were satisfied with a reporting method designed for investment in traditional asset classes. This method proposes a mean variance structure that is totally inappropriate for the risk and return profiles of alternative investment and does not inform investors of extreme risk and risk factors affecting the different returns of the hedge fund strategies in which the funds of funds are invested.

To address this issue, Edhec launched, in 2004, an international consultation process for the implementation of a new framework for Funds of Hedge Funds reporting. This consultation process was based on a series of recommendations proposed by Edhec with regard to the academic state-of-the-art on risk measurement in the alternative universe.

Positive feedback from the industry

We received answers from 98 institutional investors and fund managers who spontaneously took part to our study. Notwithstanding the fact that collecting 98 questionnaires from experienced professionals allowed a consensus to be established on the information required for the implementation of a relevant reporting method in the field of alternative investment, market participants’ commitment is in my view a strong sign of their interest and trust in Edhec Risk research. This confirms that we are digging in the right direction.

Compromise between investors’ need for information and fund managers’ propensity for secrecy

Interestingly, despite somewhat conflicting goals, investors and fund managers, except for slight discrepancies, globally agree on the definition of relevant information, and as a result on the content of the reports of tomorrow. This is a very encouraging result.

Investors and fund managers appear to be favourable towards monthly frequency and require a report with three major levels of aggregation, namely at the Strategy Group, Strategy and Fund levels. As you can see, they do not require full transparency or disclosure funds of hedge funds single positions. In an attempt to mitigate the risk of a data overkill effect, Edhec even suggest fitting the quantity of information to the aggregation level, i.e. detailed information at the Strategy Group level and thoroughly selected information at the Fund level.

Key findings of the Edhec Funds of Hedge Funds Reporting Survey

Market participants are progressively adapting their tools to the specific features of hedge funds. They agree that funds of hedge funds reports should:

  • Properly inform investors on the level of risk: investors should be provided with indicators covering the whole spectrum of risk, namely normal risk (e.g. volatility), loss risk (e.g. maximum draw down) and extreme risks (e.g. modified Value-at-Risk). Risk-adjusted performance indicators should also span these different definitions of risk so that investors can be provided with relevant information, whatever their risk preferences.

    As a matter of fact, 46% of fund managers and 74% of investors consider that a Style Value-at-Risk should be disclosed to investors. 37% of fund managers and 48% of investors favour disclosure of a Modified Value-at-Risk. In a study published by Edhec in 2003, only 20% of fund managers included a Value-at-Risk estimation in their reports. In the same vein, while the Sharpe ratio remains a must for 77% of fund managers and 79% of investors, the Omega ratio is now required by 57% of fund managers and 48% of investors. For comparison purposes, in the study published by Edhec in 2003, only 4% of fund managers considered the latter ratio as important to very important.

  • Properly inform investors as to the nature of risk: investors should be provided with information on the key determinants driving fund of hedge fund performance (e.g. volatility risk, liquidity risk, credit risk, etc.), so that they can gain a better understanding of the fund’s risk profile, and as a result ease its integration into their global allocation process. This can be done with static/dynamic style and factor analysis.

    According to the study published by Edhec in 2003, only 47% of fund managers included a style analysis in their activity reports. 67% of fund managers and 84% of investors now consider that both static and dynamic style analysis should be found in fund of hedge fund reports. For factor analysis, these figures are 56% and 85% respectively. 73% of fund managers and 90% of investors would also like to find unconditional/conditional correlations with risk factors.

  • The information in tomorrow’s funds of hedge funds reports for institutional investors

    There is an obvious convergence between the intentions of market participants and academic recommendations indicating that the process of industrialisation in the alternative arena will shortly begin to bear fruit. In particular, it suggests that fund managers plan to increase their efforts to improve the quality of their reports in an attempt to live up to increasingly demanding investor expectations. It is definitely an encouraging sign for investors who are still reluctant to dip their toe into the ocean of hedge fund strategies because of deficient investor information.

    The next step

    It will be interesting to see whether market participants’ good intentions are followed by concrete changes in practices. This is what we will see in the second edition of the Edhec Funds of Hedge Funds Reporting Survey, planned for the end of 2006.