Few of us walk down the street with a blindfold on – too many bollards, other pedestrians, plus the possibility of something unsavoury underfoot. Similarly, transparency provides investors with some comfort of arrival at the expected level of returns, with relatively few stumbles along the way. Conventional long-only funds, operating within a defined regulatory framework, are more or less likely to track returns on the underlying asset class. With the myriad different strategies and combinations of asset classes used in hedge funds, understanding the drivers of returns can be a tall order, even if managers, who are notoriously protective of their perceived trading advantage, can be persuaded to release information. This lack of transparency can be a barrier to investment, as a study on fund of funds investment by institutions recently released by Barra Strategic Consulting Group reveals.
Typically, hedge fund managers exercise ultimate discretion in decisions regarding risk and reward, jealously guard their trading strategies lest they be taken up by others, focus almost exclusively on return, and seek to avoid regulatory constraints and compliance issues that might create a drag on performance. Contrast this with the stance of pension fund trustees, who need to understand the investment strategy before committing money, may seek to circumscribe a manager’s strategies to fit in with overall objectives, are conscious of peer group comparisons, must comply with laws on fiduciary responsibilities and requirements, and prefer a stable, consistent investment process independent of a single individual.
The report issued by the Investor Risk Committee (IRC) of the International Association of Financial Engineers (IAFE) could provide a way out of this apparent impasse by laying down a route-map for regular reports to investors that should not impede the pursuance of the investment strategy.
The IRC sets out three primary objectives in disclosure: monitoring the risk of the individual fund or manager; risk aggregation, to allow investors to identify portfolio level implications; and drift monitoring, to ensure a manager is adhering to the intended style. Although some IRC members receive full position disclosure on hedge fund investments, the IRC felt that, in general, this was not the appropriate solution. Rather, the IRC paper puts forward guidelines for reporting summary risk, return and position data under four broad sub-headings, those of content, granularity, frequency and delay.
Content could include a diverse range of measures relating to risk, return and positions on an actual and stress-tested basis. Examples might be aggregate exposure to different types of asset class, geography, cash, correlations, and stress-tested NAV. Complex strategies demand options-based risk measures such as delta and gamma, or reporting on key spread relationships.
Granularity refers to the level of detail and could bring in other risk measures such as tracking error and risk factors related to region, asset class, duration or concentration. Dependent on the size of fund, it may be appropriate to report the 10 largest exposures, by name or in a generic way, characterising them by asset class, sector or region.
The frequency of reporting depends on the type of fund and its turnover, and could be as often as monthly. Delay refers to the period after which individual position data could be disclosed. Investors cite operational issues in processing vast quantities of data as an obstacle to full position disclosure. David K A Mordecai, IRC member and editor of Journal of Risk Finance, warns “unless an investor can understand and do something with this information, there is very little point in having it. In accepting too much data from the manager, an investor could find his legal position compromised in the event of fund failure.”
Andrew Lo, Harris & Harris Group professor of finance at the Massachusetts Institute of Technology and fund manager at AlphaSimplex Group, describes in his 2001 paper, ‘Risk management for hedge funds: Introduction and Overview,’ a hypothetical fund called Capital Decimation Partners. This exhibits stellar total returns over a seven-year period, few negative months, low correlation with and Sharpe ratios well in excess of the S&P500 index. The notional strategy was simply writing out-of-the-money puts on the S&P index, which, analogous to writing insurance, yields steady returns for a period of time, until an eventual claim. Full position transparency might expose this chicanery, but as Lo describes, put writing can be synthesised in such a way that unless analysis exposing the dynamic aspects of the trading strategy
is available, the risks inherent in the fund will be hidden.
Mordecai echoes these sentiments, saying “it is as important to know the ‘how’ of a trading strategy, and matters such as trade construction, financing, entry and exit level, as simply knowing the ‘what’”. On the thorny issue of hedge fund leverage, IRC members agreed that market, credit, leverage, liquidity and operational risks were interrelated. As Mordecai explains “there is no market standard for reporting leverage that translates across different funds and fund strategies. What is prudent will depend on the strategy characteristics and has to be thought about in the context of market liquidity and risk, asset volatility and allocation.”
Both Lo and the IRC paper express reservations about the use of value-at-risk (VAR). VAR is an estimate, with a predefined confidence interval, of the maximum loss from holding a position over a set horizon. Systems such as JP Morgan’s RiskMetrics use historical returns to forecast volatilities and correlations and so estimate market risk. But these variables alone cannot capture the full spectrum of risks taken on by hedge funds. For instance, a typical equity long/short fund may have risk components that relate to investment style, fundamental analysis, industry and capitalisation, portfolio optimisation, access to stock loan, execution costs and tracking error. A typical fixed income hedge fund is exposed to risk factors such as yield curve models, prepayment models (for mortgage-backed securities), option features, credit risk and macroeconomic conditions. VAR assumes a normal distribution, whereas hedge fund returns are asymmetrically distributed, highly skewed, with fat tails, implying a greater likelihood of tail events than a normal distribution would predict. VAR calculations assume static correlations whereas, in adverse market conditions, losses can arise concurrently in previously uncorrelated assets. One way this non-linearity manifests itself is variation in a fund’s beta, depending on whether markets are moving up or down. Emerging market equity funds were cited by Lo as displaying in up markets a beta of 0.16, versus 1.49 in down markets!
In reality, accurate identification of hedge fund risks by pension funds boils down to two choices: either employ a consultant to select funds and provide risk monitoring, or use a risk assessment service to extract data on pre-existing holdings and generate risk reports.

As EIM’s Eric Bissonnier explains, access to risk information is as important for portfolio construction as it is for portfolio monitoring. Aggregating risk across individual hedge funds provides comfort that the portfolio works in most market conditions. Bissonnier reflects “performance attribution can show what aspects of risk are generating fund returns”. Components such as sector exposure, net long/short exposure, country, leverage, capitalisation bias are key to evaluating equity long/short funds. For convertible bond arbitrage, additional factors like average credit rating, use of asset swaps, hedge ratio, average premium, sensitivity to interest rates and volatility are important. The variety of strategies employed in fixed income hedge funds make it difficult to pinpoint universal risk measures. As Bissonnier says “by understanding fund cyclicality between quarters and within quarters, one can ensure that any attempts to diversify add value. Consistency and predictability of returns are more important than finding the top-performing manager over any one period. One has
to be mindful that it is not always easy to get money out.”
The risk service offered by GlobeOp Financial Services is tailored to individual clients’ requirements and by combining risk skills with operational expertise GlobeOp can provide additional features that guard against manager fraud. In the first instance GlobeOp provide position and cash reconciliation, using manager, custodian and prime brokerage data. As Jerome Barraquand, managing director at GlobeOp, affirms “understanding the tail risk is key, and few other parties can do this. Strategy exposures to high yields, swap spreads and falling equity prices may not be obvious unless the strategies are understood in detail, for example decreasing returns from merger arbitrage in falling equity markets. Each manager has their own style and the challenge is to express the differences in a quantitative way.”

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