Felix Goltz and David Schroeder EDHEC Risk and Asset Management Research Centre
Like any investors, investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment, and whether this allocation yields positive returns or not. It is not only information on past investment returns that is of particular interest; prospects for future gains or losses are relevant to investors as well.
Yet, unlike mutual funds, hedge funds are reluctant to provide detailed information on their investment portfolios. Since many hedge funds use highly speculative investment strategies, fund managers fear that a thorough disclosure of their portfolio holdings would significantly decrease the chances of winning their bets, and thereby reduce investors' returns.
But incomplete disclosure can have some undesirable side effects. It might open the door for hedge fund managers to change their investment strategy or to include investments in the portfolio that are riskier than provided for by the managers' mandate. Investors even risk fraudulent behaviour, since the action of the hedge fund management might be detected only when a fund has failed.
The remarkable rise of the hedge fund industry over the past decade has aggravated the problem. In the past, the typical hedge fund investor was a wealthy private client, but more recently institutional investors have increased their stakes in hedge funds considerably. These investors, such as pension funds or insurance companies, have more sophisticated investment objectives and therefore require greater disclosure, in part because they have to render accounts to their own investors.
In this light, it is clear that hedge fund reporting can be a source of tension between investors and hedge fund management. The objective of this survey is to shed light on current industry practices in order to establish an industry benchmark for hedge fund reporting in Europe.
The EDHEC Hedge Fund Reporting Survey is representative of the European hedge fund industry
To obtain a comprehensive view of industry practices, the EDHEC Hedge Fund Reporting Survey targets the three main professional groups of the European hedge fund business: hedge fund managers, fund of hedge fund managers and hedge fund investors, all of which are equally represented in the survey.
The survey participants are mainly medium-sized companies, with assets under management (AuM) of between €100 million and €10 billion. However, some major firms with more than €100 billion in AuM respond to the survey as well. Moreover, about half of the 214 survey respondents are high-ranking executives (CEOs, managing directors, CFOs).
To shed light on hedge fund reporting, the survey contains sections devoted to issues of particular interest to hedge funds. Whereas the first set of questions asks more general questions on the importance of and satisfaction with current hedge fund reporting, the other sections address very specific topics, such as appropriate performance measures, liquidity and leverage risk indicators, or the difficulty of sensitive operational risk reporting. We present below the main results of this survey.
The quality of hedge fund reporting is an important indicator of a fund's overall excellence and thus a crucial investment criterion
One of the most important findings of this survey is that the hedge fund industry unambiguously believes that a fund's reporting quality is an indicator of the overall excellence of a hedge fund. Furthermore, we find that reporting quality is essential for investors' decisions to invest in a hedge fund. In fact, this study shows that more than 70% of all investors have internal disclosure requirements that must be met before they invest in a hedge fund.
Figure 1: Is Hedge Fund Reporting an Important Indicator for a Hedge Fund’s Overall Quality?
Next, we examine what industry practitioners believe to be the main objectives of hedge fund reporting. Most practitioners think that the main objective of hedge fund reporting is to assess the risk/return profile of the hedge fund under consideration. Risk information for the investors’ total asset allocation and performance attribution are also considered important objectives of hedge fund disclosure.
Hedge fund managers are not aware of their clients’ true information requirements
The EDHEC survey reveals that hedge fund managers are not well informed of their investors’ needs for information. We find that, in general, investors consider much more information relevant to risk assessments of a hedge fund than do managers of the hedge funds themselves.
Figure 3 illustrates these results by presenting the perceived importance of components of hedge fund disclosure by professional group. As can be seen, the perceived importance of information differs most about information on liquidity risk, operational risk and the portfolio composition of hedge funds, implying that investors wish to see much more disclosure on these issues than fund managers consider necessary. Other great differences are apparent when it comes to the qualitative outlook, risk-adjusted performance and the beta exposure of a fund. When the facets of risk and performance disclosure are compared, hedge fund managers think that information on risk-adjusted returns is relatively more important to investors. However, investors themselves regard this aspect as least important; they stress the relevance of information on past returns and extreme risks.
Figure 3: What is Important for a Good Hedge Fund Report?
Answers by Professional Group
Finally, we also find that hedge fund managers use many risk and performance measures without disclosing them to investors, believing that their investors are uninterested in these additional indicators. Since hedge fund disclosure is designed to inform investors, this divergence in the views of what information is important is an obstacle to hedge fund investment.
Current hedge fund disclosure practices do not meet the demands of investors.
Figure 4: Hedge Fund Reporting – Wishes and Reality
Answers by Fund of Hedge Fund Managers and Investors
As a direct consequence of scarce information, current hedge fund reports do not satisfy the informational requirements of investors. Although hedge fund reports are perceived to provide consistent, clear, and sufficiently frequent information on past returns, many crucial issues of hedge fund risk are left unaddressed.
Figure 4 illustrates some of the perceived shortcomings of hedge fund disclosure by opposing perceived importance with the perceived quality of aspects of hedge fund reporting. The scatter plot thus makes it possible to detect aspects of hedge fund reporting that are judged very important, but that do not yet comply with the investors’ requirements (upper left part of the plot).
These missing aspects include – most important – information on a fund’s liquidity risk, operational risks and factor exposure. Other topics viewed as neglected in hedge fund reporting are information on leverage risk (53% of all responding investors are dissatisfied with leverage risk disclosure) and the valuation framework.
Hedge fund managers tend to overestimate the quality of their reporting
The EDHEC hedge fund reporting survey also presents evidence that many hedge fund managers overestimate the reporting quality of their funds. As Figure 5 shows, hedge fund managers view the information they disclose much more highly than do their investors. The gap between the managers’ and investors’ views of the quality of information on auditing and compliance with the fund’s private placement memorandum (PPM) is particularly wide. There are similarly divergent views on the quality of reporting in general. Whereas almost all investors consider the information contained in hedge funds as sufficient to assess the reporting quality, more than half the managers disagree. In contrast, fund managers agree that their information disclosure on issues concerning valuation or internal controls is insufficient.
Figure 5: Does Hedge Fund Reporting Provide Investors with Sufficient Information on…?
Answers by Group
Inappropriate risk measures, performance indicators and reporting practices prevail in the hedge fund industry
We also find that inappropriate performance measures prevail in the hedge fund industry. The table below summarises some of these problems. Although many empirical studies present evidence that the Sharpe ratio, for example, is not suitable for risk-adjusted hedge fund returns, many respondents still believe in this measure. Likewise, most of the funds that report factor exposure rely on standard linear factor models, though empirical research has shown that non-linear factor exposures play an important role in hedge fund returns. In addition, many industry participants want to see a hedge fund’s alpha calculated with respect to a hedge fund index or a peer group of hedge funds. However, these techniques are appropriate neither as benchmark nor as a means of calculating a fund’s abnormal return, since they are too crude and thus do not reflect all risks related to hedge fund investment.
The smoothing of hedge fund returns as a result of illiquid assets is another critical point. Although academics have proposed adjustments to correct for overly smooth hedge fund returns, they are rarely used. Finally, a substantial fraction of survey respondents judge manager estimates to be a suitable way to price hard-to-value assets. This practice, however, might induce managers to misstate the returns of their hedge funds deliberately. In short, the hedge fund industry is still beset by many inappropriate reporting practices.
Table 1: Overview – Academic Standards and Current Industry Practices of Hedge Fund Disclosure
When comparing the information required by investors with the guidelines and best practices as issued by industry associations and professional organisations (such as the Alternative Investment Management Association, Hedge Fund Standards Board, and others), our study finds remarkable shortcomings. Although these guidelines are the most important information source for the hedge fund industry (refer to Figure 6), and thus have a great impact on the hedge fund industry, they rarely provide guidance on sound hedge fund disclosure.
As table 2 shows, many of these guidelines are very vague and cover topics where there is already standard disclosure, such as about the general hedge fund structure or information on past returns. Hence, these best practices fall short of encouraging hedge funds to provide information on very important aspects of hedge fund risks. Guidelines for disclosure of a fund's risk-adjusted returns, extreme risks, leverage and liquidity risk, or its factor exposure are given especially short shrift.
Table 2: Guidance of Industry “Best Practices” on Optimal Disclosure of Hedge Funds
The results of this survey have a number of implications for the hedge fund industry. First, great differences between hedge fund managers' perception of relevant information disclosure and their investors' needs suggest that the industry should expand overall disclosure. Although there might be good reasons not to disclose, in great detail, the portfolio composition of hedge funds, many other aspects for risk reporting could be easily improved without putting a hedge fund's investment strategy in danger.
Second, hedge funds should move to more appropriate risk and performance measures when disclosing their returns to investors. A large body of academic literature shows that many prevailing risk measures are unsuitable for reporting the true economic risks of hedge fund investment. The problem is not that there are no meaningful indicators, but that they are not actually used.
Finally, the evidence on hedge fund reporting practices suggests that current guidelines and best practices of industry associations are unlikely to boost hedge fund transparency, and thus investor confidence. Guidance on optimal disclosure of a fund's risk-adjusted returns, extreme risks, leverage and liquidity risk, or its factor exposure is often neglected. To ensure greater hedge fund transparency, existing guidelines should be extended to cover these risks as well. It is important to note that this statement should not be misinterpreted as a call for more regulation of the hedge fund industry. Nonetheless, better reporting is likely to benefit all those involved in the industry.
Felix Goltz is head of applied research at the EDHEC Risk and Asset Management Research Centre. He conducts research in empirical finance and asset allocation, with a focus on alternative investments and indexing strategies. His work has appeared in various international academic and practitioner journals and handbooks. He obtained a PhD in finance from the University of Nice Sophia – Antipolis after studying economics and business administration at the University of Bayreuth and EDHEC Business School.
David Schroeder is a senior research engineer at the EDHEC Risk and Asset Management Research Centre. Schroeder obtained his PhD in economics from the University of Bonn. During his doctoral studies, he was also affiliated with the Centre de Recherche en Economie et Statistique (CREST) in Paris. His research focuses on empirical asset pricing, the predictive power of equity analysts’ forecasts, and decision making under ambiguity. He is a member of the Econometric Society and has presented at many international economics and finance conferences.