Rating Revisions

Fitch reviews its fund of hedge fund ratings process

AN EXCERPT FROM FITCH RATINGS’ FUND OF HEDGE FUND MANAGERS CRITERIA REPORT

Summary
Fitch’s asset manager rating methodology, which was first developed in 1998, is designed to systematically capture, evaluate and report on an asset manager’s key characteristics via a multi-faceted approach, which provides for the aggregation of the rating factors into five distinct groupings. This allows Fitch to achieve focused analysis, to clearly express rating conclusions and to profile rated asset managers. Qualitative inputs from analysts also serve as the defining input in the assignment of the final ratings, allowing for the consideration of individual asset managers’ circumstances.

The categories reviewed in the context of FoHF managers are as follows:
• Company and staffing;
• Fund/manager selection;
• Portfolio and risk management;
• Investment administration; and
• Technology.

Fitch’s asset manager ratings are announced via rating action commentaries and followed by rating reports. All asset manager ratings are updated at least annually; in the interim, these ratings are subject to ongoing monitoring and rating actions may be taken if deemed necessary by Fitch.

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Rating criteria overview
Fig.2 offers a conceptual view of a typical funds of hedge funds investment process. Each phase comprises sub-processes and tasks, and the process is executed in environments where differing levels of infrastructure support risk management and operational control objectives. The Fitch manager rating criteria and scorecard for funds of hedge funds have been developed to mirror the fundamental aspects of the process and account for key indicators of the quality of the process as well as related infrastructure, risk management practices and operational controls.

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As a company’s financial standing is a decisive factor in its ability to ensure business sustainability, an asset manager’s overall rating may be capped by its score in the shareholding and financial standing sub-category, should the financial condition of the rated manager or its parent company be of concern to Fitch’s analysts. The agency is working closely with its financial institutions group to update its financial analysis of asset managers and refine the relationship with the overall asset manager rating. It should be noted, however, that in the context of a manager rating, financial condition is not assessed with the same perspective as that of a credit rating. Although a credit rating gives a good indication of the financial condition of a company, it is important to bear in mind that debt-holders and counterparties – excluding fund investors – may well suffer economic losses, whose likelihood is measured by credit rating measures, while the company may still remain viable and continue to perform its asset management duties in the best interests of investors.

Rating process overview
Fitch’s asset manager rating review process is designed to assess relevant information, consistently apply criteria and uniformly disclose the agency’s rating rationale. The process incorporates five stages, as illustrated in Fig.3.

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Pre-assessment: Fitch utilises pre-assessment measures to determine whether it believes the asset manager can provide sufficient information on the following points to allow Fitch to proceed with the rating analysis. (See Fig. 3)

• Can the asset manager demonstrate the sustainability of the investment services provided to investors, based on the following considerations: financial viability of the organisation; business model; asset- and product-related risks; experience of the organisation; level of external and internal oversight; and third-parties connectivity?

• Is the asset manager willing to disclose relevant non-public information to Fitch such as investment team background, research reports, meeting minutes, risk analysis and reports? It should be noted that the provision of non-public information to Fitch by the asset manager, as well as the use that Fitch may make of it, are covered by the agency’s Code of Conduct and related policies. In addition, prior to the on-site review, the asset manager being assessed is asked to provide a set of documents designed to capture organisational, financial, operational and portfolio and personnel-related information. This information is reviewed to create a targeted agenda for the onsite review.

On-site review:

The on-site review serves to assist Fitch in understanding the organisation’s processes and controls. It typically consists of interviews with executive management, the senior management of the different functional groups and their staff – typically in the areas of portfolio management, research, middle-office, back-office, IT, reporting, audit and risk control. In addition, the agency is given system demonstrations.

Analysis:
Fitch uses an ordinal scoring approach to evaluate asset managers. This approach facilitates the consistent application of the methodology while minimising subjective variations in scoring qualitative characteristics. This is accomplished through the use of a scoring guide that defines all score levels for each factor within Fitch’s analysis. Each factor is assigned a relative weight within the grouping of factors to generate group scores for all five main criteria, which are also assigned relative weights to determine the overall asset manager rating (see Fig. 1). Points awarded for most factors in Fitch’s analysis are based on relative assessments considering standard and best practices, and comparison among rated asset managers. Some involve the awarding of points based on numerical measures or rank among peers, while others are based on the relative strength or merit of a quality or condition. The weighting of the factors represents Fitch’s estimate of the relative importance of a factor within the related category based on the collective judgement of the agency’s senior analysts. The factors, weightings and asset manager-specific analytical conclusions are aggregated by Fitch in an internal scorecard application. See Fig 4 for an abstract of this scorecard.

fitch4Together, the scorecards and scoring guides developed by Fitch serve as conceptual tools that ensure the consistent application of the rating methodology. However, like any tool with fixed parameters, scorecards are not perfect and Fitch does not, therefore, rely solely on a measurement on the scorecard; the circumstances of individual asset managers are also considered. Qualitative input from members of the rating committee will serve as the defining input in the assignment of the final ratings. Ultimately, rating decisions will be guided by the rating definitions in each of the five rating categories. The rating committee, composed of on-site visit attendees and other senior analysts, validates the scorecard results and rating rationale, and determines the rating.

Ratings assignment:
Upon committee approval, the ratings will be issued via a rating action commentary – that includes the key elements of the rating rationale – followed by a rating report, all published on the agency website, www.fitchratings.com, which is freely available. The reports provide a profile of the company and personnel, processes, resources and operations and a summary of the scoring and rating rationale.

Surveillance:
All asset manager ratings are updated at least annually with ongoing monitoring and surveillance. Topics covered through this ongoing monitoring primarily include:

· corporate activity;
· staff evolution;
· assets under management; and
· major projects underway.