Improved reporting is seen as a key indicator of a hedge fund's overall quality, writes Kris Devasabai

Hedge funds may be making money again, but the steep losses in 2008 and the Madoff fraud have prompted institutional investors to push for changes in the way the industry operates. There is growing pressure on hedge funds to appoint independent administrators to value fund assets, as well as demands for greater transparency and more frequent reporting from managers.

Investors are understandably wary of the Madoff scenario, whereby monthly position statements and reports were prepared and issued by the fund itself without any external verification, and are calling for portfolio positions to be reconciled and valued by a reputable and independent third party.

Earlier this year, Swiss bank Union Bancaire Privée, one of the world’s largest investors in hedge funds, threatened to redeem assets from managers that selfadministered their portfolios. That prompted a number of well-known hedge funds like Millennium Management and SAC Capital, which had previously valued their own assets, to appoint an independent administrator.

Investors are also taking a closer look at the processes and models used by administrators to reconcile and value portfolio holdings as part of the due diligence process. There has been a notable increase in the number of investors performing due diligence on fund administrators since the turn of the year, says Jim Cass, a managing director in SEI’s Investment Manager Services division.

“There is a real demand for operational transparency. Investors increasingly want to speak to us independently about the valuation process. They are checking everything from the reference data sources to the control framework and the level of independence from the manager. Investors will not commit capital to a fund unless they are comfortable with all aspects of the valuation process,” says Cass.

The heightened focus on valuation has sparked concerns among investors around what is commonly known in hedge fund circles as ‘NAV Lite’. This is a practice whereby the hedge fund appoints a third party administrator to verify the figures produced by the manager, often for a nominal fee.

Under pressure
“There is pressure on the industry to ensure the valuation process is truly independent from the manager. Investors are digging into the business model of the administrator and making sure they are using independent data sources and pricing models to calculate the NAV, rather than simply signing off on the figures produced by the manager,” says Christopher Kundro, co-chief executive officer of Lacrosse Global Fund Services.

Kundro believes there is still some disagreement between investors and fund managers with regard to what constitutes independent administration. Lacrosse continues to be approached by managers seeking a stripped-down and low-cost administration service, but Kundro says the company has made it a point to turn away this business. “It is not part of our business philosophy to provide ‘NAV Lite’. The manager has to be prepared to hand over the entire process of fund valuation to the administrator. That is what investors are demanding from hedge funds,” says Kundro.

Appointing an independent administrator is only the first step towards meeting the increased requirements of institutional investors. The losses suffered in 2008 have convinced investors of the need to gain a better understanding of the risks within their hedge fund holdings, which has led to calls for greater transparency and reporting from hedge funds.

The average hedge fund lost around 18% in 2008, according to data from Hedge Fund Research. This was the industry’s worst performance since the Chicago-based research firm started keeping records in 1990. Hedge funds still outperformed long-only managers, who were left nursing average losses of almost 40% as a result of the collapse in equities. But investors were hugely disappointed with the level of correlation between hedge funds and traditional markets and the failure of the industry to deliver on the promise of absolute returns irrespective of market conditions.

To make matters worse, a number of hedge funds infuriated investors by either suspending redemptions or imposing gates when investors sought to cash out of their investments as market conditions worsened.

These experiences have undermined investor confidence in hedge funds, says Ross Ellis, vice president of marketing at SEI. “Investors are sceptical and fearful. They know what they were sold, but they are unsure of what they bought. One of the cures for that is for the industry to be more open about its activities and be more transparent with investors,” he says.

Concerns about transparency have led to greater interest in managed accounts, where money from individual investors is held separately and position holdings are transparent. In the past, hedge funds rarely offered this type of structure because of the additional costs and operational burden of running them. But managed accounts “have been proliferating” since the turn of the year, says Ellis.

“Investing through a managed account gives the investor greater transparency and control over their assets than a traditional commingled fund. The investor can monitor the positions and the risk in the portfolio, and will not be impacted if other investors decide to redeem,” says Ellis.

But the costs associated with running managed accounts means they are likely to remain the preserve of only a few large investors with the financial muscle to dictate their own terms. The majority of investors have focused on obtaining greater transparency into portfolio positions in commingled funds and more meaningful exposure and risk reports.

According to a survey by EDHEC Risk and Asset Management Research Centre, 92% of investors believe the quality of hedge fund reporting is an important signal of a fund’s overall quality and pivotal for decisions about hedge fund investment. A separate survey conducted by State Street found that 84% of investors expect more disclosure of positions from hedge funds. Only 19% of investors said they currently received some level of consistent transparency across their hedge fund holdings.

Fund administrators can play an important role in helping hedge funds to meet investor demands for greater transparency. “Fund administrators are in an ideal position to provide risk and exposure reporting to investors because they have access to the verified books and records of the hedge fund,” says Vernon Barback, president and chief operating officer of GlobeOp Financial Services. “Engaging the administrator to provide enhanced risk and exposure reports to investors is probably the simplest and cheapest way for hedge funds to respond to the demand for greater transparency,” he adds.

Fund administrators already have the tools to provide full position level transparency to investors, but managers are often reluctant to take advantage of this. “The technology is already there. We can provide access to the underlying books and records of any fund we administer through a secure online portal. That information is currently available to the manager. It is up the manager to decide how much of that data they want to provide back to their investor,” says Dennis Westley, managing director of alternative investment services at PNC Global Investment Servicing.

But he says it is extremely rare for hedge funds to provide full position level transparency to investors. “That could change, either as a result of investor pressure or regulation. If it does, we are equipped to handle those requirements,” adds Westley. Hedge funds have always been hesitant about disclosing position level information for fear of revealing the ‘secret sauce’ that enables them to generate outsize returns, and in reality, only a handful of investors are sophisticated enough to make sense of this data.

Meeting in the middle
A compromise solution that is steadily gaining momentum is for investors to be given aggregate risk and exposure reports based on position level data from the administrator. This model gives investors access to the information they require while protecting the underlying positions of the hedge fund. These reports could be prepared by the administrator itself or a third party like RiskMetrics or Investor Analytics.

The issue here is that translating position level data into analytics and aggregate reports that give investors a real insight into the risks in any given hedge fund portfolio is a complex task.

The type of information required by investors differs markedly according to the way the investor views risk. While some investors use Value at Risk (VaR) as their principal measure of risk, others prefer to stress-test their portfolios in various market scenarios.

The information sought by investors will also vary depending on the types of hedge funds they are invested in. For instance, an investor in a long/short equity fund may be satisfied with basic exposure reports across sectors and industries, but this will be of limited use to an investor in a global macro fund trading currencies and interest rates as well as global equities and fixedincome securities.

“A one-size-fits-all approach to reporting is not appropriate for the hedge fund sector. In order to provide a meaningful service, administrators must develop systems that allow managers to tailor reports according to the transparency and information needs of their investors,” says Cass.

In March of this year, PNC launched a software application for its fund administration clients called Intelligent Dashboard. This is designed to simplify the storage and communication of fund-related data. The Dashboard is automatically updated with position level data and can be customised by the manager to produce and deliver reports to investors according to predetermined parameters. This means the manager can control the granularity of information available to investors.

GlobeOp has been providing risk fund clients since 2001. In July the company announced it had integrated these tools within its investor communication platform, known as GoBook. Barback says the integration of its risk and investor communication tools allows GlobeOp’s clients to provide their investors with a range of portfolio risk reports alongside their monthly statements and performance data with a minimum of fuss.

He believes fund administrators will increasingly be expected to provide this type of service as part of their standard offering. “There has been a marked increase in the level of investor appetite for all types of risk reports, from operational risk to credit risk and liquidity risk to market risk. The administrator is in the best position to supply this information because they have access to the official books and records of the fund, but they need to develop sophisticated risk analytics tools in order to give investors the information they need in the right format,” says Barback.

It has taken GlobeOp a number of years of research and development to create a sophisticated set of flexible risk-reporting tools for hedge funds, says Barback. “We have a library of over 50 different report types that can be made available to investors through GoBook depending on the individual needs of the investors. Risk reports customised to the specifications of the fund or its investors can also be uploaded onto the system by the managers. It takes a significant investment in technology and intellectual capital to create a meaningful risk-reporting service,” he says.

Working together
The complexity of collecting data and running risk analytics on hedge funds means it often makes sense for fund administrators and custodian banks to work with third-party risk specialists like RiskMetrics and Investor Analytics to cater to the demand for better reporting. BNY Mellon has had an equity stake in Investor Analytics for five years and has worked closely with the company to develop risk analytics services for its hedge fund administration clients. In June, the companies formed a strategic alliance whereby Investor Analytics’ risk reports will be made available to the bank’s custody clients, such as pension funds and banks.

“Attempting to collect information from thousands of individual hedge funds to run risk reports for investors would have been a difficult task. It made more sense to work with Investor Analytics, which has a long history of working with hedge fund managers. They provide data to Investor Analytics safe in the knowledge that their positions will not become public. Investor Analytics runs the analytics on the fund based and we can provide that information back to our clients,” says John Gruber, head of global product management for performance and risk analytics at BNY Mellon.

The deal with Investor Analytics will enable BNY Mellon to give its clients an holistic view of their risk exposures, bringing their hedge fund holdings alongside traditional investments held in the custody account.

“Hedge funds should not necessarily be viewed as a separate asset class. They invest in a lot of the same securities as traditional asset managers, only with different trading styles and strategies. It is important for our clients to have a view of how the exposures in their hedge fund holdings could exacerbate or mitigate the risks in the rest of their portfolio,” says Gruber.

A number of other custodian banks and administrators are interested in replicating the model established by BNY Mellon and Investor Analytics. RiskMetrics, which provides a similar service to Investor Analytics, has seen increased demand from administrators and custodian banks in licensing its analytics tools, according to Brian Schmid, head of the company’s alternative investment business strategy.

Fund administrators that license RiskMetrics’ software use it to generate reports which are then white-labelled from consumption by investors. The company also has direct relationships with 250 hedge funds and institutional investors, who between them have around $200 billion invested in hedge funds. Schmid says the sheer complexity of hedge fund trading strategies is driving interest in RiskMetrics’ capabilities. “There aren’t many companies that can model the risk of what hedge funds trade. The other big challenge is data collection. We have relationships with all the major custodians and fund administrators and they feed us the data required to run the analytics on hedge funds,” he says.

Last year RiskMetrics launched a free service called Hedge Platform Community (HPC), which it plans to develop into an industry hub for risk information on hedge funds. Fund managers are invited to report portfolio positions to HPC and in exchange they can issue monthly reports based on RiskMetrics’ methodologies to their investors free of charge.

Fund administrators can also participate in the platform by becoming a ‘trusted data provider’ to RiskMetrics. This allows the administrator to offer its clients membership of HPC. Members then receive a free application which can be used to create free monthly risk reports for investors based on RiskMetrics’ analytics.

Schmid says HPC could be particularly useful for smaller administrators that lack the resources to develop an in-house riskreporting service. “The large administrators are putting a lot of money into developing a risk-reporting component to their services. HPC offers a way for smaller administrators to compete with the bigger players in this area,” he says.