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Asset Allocation and Alternative Diversification

EDHEC-Risk Funds of Hedge Funds Reporting Survey

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-Risk Institute 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-Risk Institute 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-Risk Institute with regard to the academic state-of-the-art on risk measurement in the alternative universe.

Over the last four years, EDHEC-Risk Institute has been developing a series of research programmes in the area of risk and asset management with the permanent objective of responding to the interests of the various industry actors and sponsors that have been supporting the initiative. The EDHEC-Risk Funds of Hedge Funds Reporting Survey was written in this spirit. It is the first study conducted worldwide comparing and contrasting suggestions from the industry (buy side and sell side) and academic recommendations on the sensitive issue of investor information.

In the first section of this publication, we carry out a review of the literature to identify the consensus that has been reached in the academic world on the risk profile of hedge funds.

We highlight the fact that even though the specific features of the risk profile of hedge funds have been widely discussed in the literature, market participants tend to understate their importance, and remain strongly impregnated by traditional world investment practices.

In the light of our study on the specific risk profile of hedge funds, we show the extent to which performance measures traditionally used by market participants (investors and fund managers alike), such as the Sharpe ratio, face limitations when it comes to assessing the performance of alternative investments. In this respect, we argue that due to the exposure to multiple sources of risk, and due to the dynamic and non-linear nature of the relationships with risk factors, traditional risk-adjusted performance measures fail to account properly for the risk profile of hedge funds, and as a result fail to assess their performance accurately. Yet, as illustrated in EDHEC (2003)*, a large majority of investors still prefer indicators such as the Sharpe ratio (82%), the Sortino ratio (58%) or even the information ratio (49%) to monitor hedge fund performance.

In this publication, we make a number of suggestions with regard to the content of the activity report and present the principal indicators. We first suggest opting for a monthly publication frequency and list a number of indicators covering the whole spectrum of the risk and return dimension definitions. We thus give a number of measures accounting for normal risks (e.g. Volatility), extreme risks (e.g. Modified Value-at-Risk) and loss risks (e.g. Maximum Drawdown) with the corresponding risk-adjusted performance indicators so that investors, whatever their preferences, can be provided with relevant information. In this respect, it is worth noting that all this information can be obtained through a return-based analysis that is carried out by simply analysing FoHFs' historical returns. As a result, with the approach suggested in this publication, managers can provide investors with valuable information on their fund performance and risk profile without disclosing detailed positions. We thus argue that it is possible to satisfy investor requirements for information without challenging managers' requirements for secrecy. We also propose to include original risk-adjusted indicators, such as the Omega ratio, which are specifically designed to account for the non-normal return distributions of hedge funds. We finally suggest that the activity report should include detailed information on the fund's key return drivers in the form of style and factor analysis, so that investors can optimally mix alternative investments with their traditional portfolio.

We argue that such information is essential, since an increasing proportion of investors are using hedge funds to improve the diversification of their portfolio.

In the final sections of this publication, we analyse the answers to the questionnaire, and confront investor and fund manager opinions on what the future content of the monthly activity report should be. Despite some slight differences, investors and fund managers tend to agree on the definition of the relevant information. This finding contrasts sharply with what is usually said on the conflict of interest between investors and fund managers.

Nevertheless, as one might have expected, investors tend to ask for more details than fund managers. In this respect, we suggest fitting the degree of detail to the level of granularity (i.e. detailed information at the FoHF level and succinct information at the fund level) in order to reach a good compromise between the information needs of investors and the constraints of fund managers.

According to both investors and fund managers, traditional performance measures have their place in the hedge fund activity report of tomorrow. The Sharpe ratio is considered to be important to very important by 77% of the fund managers and 79% of the investors.

However, it is worth noting that new performance measures, which are better suited for alternative investments, are gaining acceptance, demonstrating the interest of market participants in rationalising the performance evaluation and attribution process. Indeed, the Omega ratio is already considered to be important to very important by 57% of fund managers and 48% of investors.

In the same vein, it seems that market participants are progressively accepting the idea that hedge fund returns are driven by beta and alpha drivers since many of them are looking for relative returns. We believe that this shift from an absolute return paradigm to a relative return paradigm is a major step forward for the future development of the alternative investment industry. However, it brings new challenges in terms of reporting to investors. Investors will be increasingly demanding with regard to information on the underlying risk factors of FoHF. For this reason we suggest including static and dynamic style/factor analysis in the monthly activity report so that investors can either study the diversification properties or measure the relative returns of FoHF.

As a conclusion, there is still a long way to go before investors in the alternative arena can be provided with relevant information on a monthly basis. Nevertheless, we can at least say that the results that we have obtained are encouraging. Investors and fund managers are heading in the same direction and they have chosen the right direction, in that they tend to suit their investment practices to the specific features of alternative investment.

While only 20% of fund managers include VaR measures in their reporting to account for extreme risks (see EDHEC-Risk (2003)*), 40% of fund managers consider that robust indicators such as Beyond VaR should be included in their reporting in the future. The same observation holds for risk-adjusted performance indicators.

While only 4% of fund managers (see EDHEC-Risk (2003)*) currently use the Omega ratio, 57% of them consider that an indicator of that kind should be part of their monthly activity reports in the future.


*EDHEC-Risk European Alternative Multimanagement Practices Survey, 2003