Hedge Fund Transparency

Cutting Through The Black Box

James R. Hedges IV

As hedge funds have grown to a $1.2 trillion plus industry, so too have the complexities of hedge fund investing. While hedge funds’ structure provides managers with the flexibility to deliver impressive returns, it also obscures their ability and willingness to monitor and report on their own activities.

Furthermore, many managers are reticent to allow clients to second guess their judgment in short-term increments. Without special considerations, it is often difficult to monitor whether a manager is diverging from the stated strategy, inappropriately using derivatives or leverage, or engaging in other unacceptable behavior. In an era marked by Amaranth and similar scandals, transparency is more relevant than ever.

Indeed, the biggest challenges facing today’s hedge fund industry may well be the issues of transparency and disclosure. Long known for its culture of secretiveness, the hedge fund industry has become more proactive in balancing the need to keep investors informed and protecting the confidentiality often essential to implementing their investment strategies.

The literal meaning of transparency is the state of being easily detected or seen through, readily understood, or free from pretense or deceit. Transparency in the hedge fund sense refers to the ability of the investor to look through its investment portfolio to determine compliance with the fund’s investment guidelines and risk parameters. Essentially, transparency allows investors to see what the manager is doing with their money.

A reasonable request?

At first glance, the request for transparency seems like a reasonable one. After all, investors would certainly not engage in blind trust with hedge fund managers who are managing a sizable portion of their wealth. They would undoubtedly want to monitor not only the overall performance of the manager, but also the nature of the trading activity and the risks undertaken. Whether hedge funds should be exempt from disclosing valuable information to the investing public is a question that continues to be debated by investors and regulators, and broader disclosure practices by hedge funds in recent years reflect these pressures.

The quiet interworkings of a competitive capital market are another reason for increased attention to the transparency issue. Competitive pressures provide an incentive to disclose information voluntarily. More investors than ever are rejecting the historical notion that hedge funds must be accepted as black box investing that keeps them in the dark. Instead, smart investors know that they need to look behind the curtain and that they should expect sophisticated strategies to be delivered clearly and concisely. Straight talk is essential.

Fund managers not willing to disclose, face increasing penalties in the form of increasing difficulties in their ability to retain existing investors and to attract additional investments from institutional investors and high net worth individuals. As a matter of fact, many funds of hedge funds and institutional investors require managers to agree to meet minimum transparency standards prior to investing in the funds.

Heightened attention

The heightened attention being paid to the industry is simply a function of the industry’s size and continuing rapid growth rate, the consequent involvement of more and more retail investors (ostensibly in need of some greater degree of protection than their highnet worth or institutional counterparts), and lastly because of the disproportionate influence of hedge fund activities (either on the part of individual hedge funds or in various aggregates) on the overall workings of the global financial system. Institutional investors use Request for Proposals in manager searches because they provide investors with information on all aspects of a firm’s organization and infrastructure and the investment strategy in question. RFPs also provide them with a tool for comparing managers and investment strategies.

Managers must be prepared to perpetuate the transparency required in the manager evaluation process in the manager-client relationship after the allocation. Investors will require that managers provide them with open, accurate and timely reporting and communication. They will expect to receive information on the source of returns, the asset allocation of the portfolio, portfolio composition, investment view, and any changes that have occurred at the firm or in the investment process. Reticence and secrecy after an allocation may well result in a prompt re-evaluation of the manager, with the redemption of assets a real alternative.

The difference between transparency and disclosure

It is important to be aware of the somewhat subtle distinction between transparency and disclosure. Hedge fund managers expect an investor to go through a due diligence process, complete an RFP and provide a private placement memorandum (PPM). Additionally, personal meetings provide opportunities to obtain information required to evaluate the fund.

However, transparency signifies something greater than the sum of any and all disclosures. A fund cannot provide transparency without disclosure. However, it can disclose all its positions and yet what a manager is up to may not be transparent, at least to most investment professionals. For example, if a fixed income arbitrage fund specializing in mortgage-backed securities were to provide its investors with detailed information on such arcane matters as IO and PO tranches, floaters and inverse floaters, etc., it would tell most of its investors very little about the level of risk of the fund. As a matter of fact, such disclosure may perversely provide investors with a false sense of security. The required analytical skills and quantitative tools needed to analyze risk in certain strategies and instruments used by many hedge funds are costly to acquire and may not be worth the cost given the size of one’s individual investments in a hedge fund. For those investors with limited ability and cost concerns, the disclosure of key portfolio characteristics suitably aggregated may be more revealing and therefore more useful in making timely assessments of a fund’s risk/return profile.

Investors should also keep in mind the ways in which a hedge fund’s structural elements (performance fees, highly flexible investment parameters, complex, illiquid investment positions) can provide both scope and incentive to managers to behave opportunistically to the detriment of investors if no one is looking over their shoulders. Unless investors are investing through a fund of hedge funds, no free ride on the due diligence and monitoring is available. With no comprehensive regulatory oversight in place, investors may feel with some justification that hedge fund managers have both the motive and the opportunity to defraud investors. Consequently, they need to know what managers are up to through increased disclosure in order to protect their interests.

Advantages and disadvantages

With those considerations in mind, let’s consider at a general level the advantages and disadvantages of transparency from both the investor and hedge fund manager perspectives.From the standpoint of a hedge fund investor, more transparency means more information available to both present and prospective investors. It means an improved ability to monitor performance and assess risks, therefore enabling fully informed investment decision making.

At the very least, transparency enables investors to become more aware before they commit themselves to an investment. Alternatively, it also enables them to be more comfortable about their personal wealth invested in a fund by reducing the levels and the likelihood of fraud, misrepresentation and price manipulation.

Transparency can also allow investors to minimize exposures to certain investments made by the hedge fund manager. For example, if an investor notices that his manager has a huge position in a particular security, that investor can choose to hedge that risk by either taking an opposite position or entering into a simple derivatives contract such as an option.

From a fund manager’s viewpoint, increased transparency has advantages as well. The process of disclosing data to fund investors can be an important communication tool for the manager at the same time it benefits investors. Managers can use disclosure as a means to educate and maintain dialogue with their investors, thereby keeping up relations with investors who are the long-term foundation of the hedge fund.

The overriding disadvantage of transparency from the fund manager’s perspective concerns disclosure of fund holdings. The greatest fear of fund managers is that their positions might become known to other traders, putting them at a competitive disadvantage. This can easily happen to a manager that has entered into a sizable, but relatively illiquid position. For example, if a large hedge fund invested a significant sum in a given security that was thinly traded, and the market maker in this security knew of this position, the market maker could easily work against the manager. In addition, most hedge funds seek out stocks that are not covered by mainstream analysts. They hope to find a “diamond in the rough” and build a large position in the stock. When a manager is building such a position, it is certainly not to his advantage to have total transparency and have the fact known. These situations have indeed resulted in disastrous trades for hedge fund managers with some regularity.

A similar concern of hedge fund managers is that competitors will replicate their proprietary trading models if full transparency is provided. Many managers develop highly complex, automated systems that are responsible for daily trading activity. The typical system contains an algorithm or neural net that generates signals on whether to buy or sell a given security or commodity. Traders develop these systems after conducting intensive research on historical price trends, volatility and other technical relationships. If competitors have access to the trades that a manager makes, they may be able to reverse engineer the models being used, putting a manager again at a significant competitive disadvantage.

At this point it is safe to say that there is no disagreement regarding the need for transparency. The real debate centers on how much of a portfolio’s position details a fund should disclose to its investors, and whether or not the disclosure of detailed information would make manager’s actions and strategies readily understood by investors.

“In an era marked by Amaranth and similar scandals, transparency is more relevant than ever”

Disclosure of information is only as good as the ability of investors to understand it in both a timely and cost effective manner. Analytical ability and cost considerations have led to the delivery to hedge fund investors of various forms of transparency and to third party financial information processing services.

As a result, a small but increasing number of hedge funds are willing to provide full transparency to their investors under guarded conditions. From the hedge fund manager’s perspective, the bottom line consideration to taking this approach is that where there are costs involved in preparing and releasing information and where certain types of disclosure may reveal proprietary information, transparency must be managed.

Separate Accounts

Separate Accounts allow full disclosure to an investor. Unlike an investor in the main partnership, the investor in a separate account owns the portfolio directly and therefore has complete transparency into each position taken by the account directly from the prime brokers. Separate accounts offer additional benefits: portfolio directives such as loss or exposure limits can be customized and unwanted asset classes can be easily eliminated. Leverage, credit and valuation errors or fraud can be easily monitored as well as deviations from investment guidelines or style drift. Stop loss rules for both individual holdings in the account and for the overall account itself can also be customized. Indeed, since the investor has direct ownership, he/she can terminate a manager at any time and assume control of the assets. Risk analytics may further be obtained directly from the prime broker at no additional charge to the investor.

The extra level of transparency and control offered by separate accounts must be balanced by the following: all costs incurred to manage the separate account (accounting, auditing, trading, etc.) are borne by the single investor rather than being proportionately borne by multiple investors. Separate accounts as result bear an increased fee burden.

In addition, fund managers typically require a high minimum to initiate a separate account. Since many hedge fund managers are unwilling to accept managed accounts, an investor insisting on this investment vehicle may have to settle for second-best managers. Because of the large required minimums, managed accounts have been a favored investment vehicle of large investment houses, institutional investors and a few large funds of hedge funds. Even supposedly sophisticated investors with cutting edge analytics and full transparency may not always be able to stop an opportunistic manager dead on his track.

A weakness of separate accounts is that they rarely achieve the goal of transparency. That is to say they still do little in keeping an investor appropriately informed and aware of a manager’s strategies and intentions. Investors need to insist on the level of transparency with which they are comfortable and only invest their money with those who meet these requirements on an ongoing basis.

James R. Hedges, IV

IVJames R. Hedges, IV is one of the early leaders in the hedge fund industry and is the author of Hedges on Hedge Funds, published by Wiley Finance. He is the Founder, President and Chief Investment Officer of LJH Global Investments, LLC, a hedge fund advisory firm based in Naples, Florida, and the Chairman of LJH Financial Marketing Strategies in Florida and New York.