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Assessing Hedge Fund Risk in a New Era of Hedge Fund Transparency

Journal 33: Technical Finance

David T. Owyong

Traditional risk management of hedge funds is often complicated by their lack of transparency. Consequently, plan sponsors traditionally rely on returns analysis to manage the risk of a portfolio of hedge funds. Such an approach involves some obvious difficulties, for example, returns data is often available only on a monthly basis and sometimes with a lag. In addition, some hedge funds have short histories or may have different fund managers over time. One compromise solution is for hedge funds to reveal their positions to a third party, such as a risk vendor, which in turn generate risk statistics and reports for the plan sponsor without revealing those positions. Risk management in this context is based on holdings rather than historical returns, and this new approach is shown to be able to bypass the difficulties involved in the traditional approach.

In the wake of the global financial crisis in 2008 and losses from the Madoff scandal, there have been widespread calls for greater hedge fund transparency from investors, regulators, and market participants. In January 2008, U.S. Senators Carl Levin and Charles Grassley sponsored the Hedge Fund Transparency Act, which was intended to introduce more transparency and disclosure from hedge funds, in the hopes that the free flow of such information would help prevent some of the hedge fund disasters in the future.

By requiring greater disclosure from hedge funds, they could be monitored more closely and so excessive risk-taking or fraudulent behavior could be uncovered much more quickly. It is, therefore, likely that some hedge fund blow-ups could be avoided before it is too late, and financial damage for investors could also be kept to a minimum. However, in the case of Bernie Madoff there were plenty of warning signs early on. The SEC had examined his fund and even warned of the risks involved, yet Madoff still caused a major disaster that will probably take years to sort out. That suggests that requiring greater disclosure from hedge funds is only a first step; individual investors should make it their own responsibility to analyze the information carefully rather than just rely on authorities to monitor and regulate the hedge funds.

The 2011 Preqin Global Investor Report on hedge funds warned that institutional investors will simply not allocate capital to hedge funds that failed to meet basic transparency criteria. The report went on to suggest that it is likely that levels of disclosure will increase in the future with transparent business practices becoming a standardized and expected element of the hedge fund industry. If hedge funds do not respond to institutional pressure for increased transparency, they not only face difficulties in gaining fresh investment but are also likely to experience large outflows as investors seek to place their capital with managers that will offer them the transparency which is deemed so important.

According to a recent poll of institutional investors by Preqin, significant numbers of investors also want the hedge funds’ risk profiles and management to be readily available [Preqin (2011)]. Such information would include regular value-at-risk (VAR) updates and counterparty exposure. It was noted that many hedge funds have already increased their levels of disclosure and transparency in order to satisfy the demands of institutional clients. This trend is likely to grow and usher in a new era of hedge fund transparency.

However, hedge funds are also concerned that making their positions public would undermine the effectiveness of their investment strategies. A compromise solution is for hedge fund to provide position-level data only to a third-party platform, which is bound by non-disclosure restrictions, and then have this platform generate risk reports to the investors without disclosing details of the positions. The popularity of this concept has led to the recent proliferation of third-party platforms, some of which have gone as far as providing intra-day performance to institutional investors. Not only is it possible to monitor performance attribution, but some platforms such as the HedgePlatform product provided by MSCI even allows for more sophisticated analysis like stress testing. It is indeed remarkable that the industry has changed so much in such a short time period.

This new era of hedge fund transparency and disclosure has major implications for investors in terms of risk management and monitoring. Traditionally, with only returns-level data available, risk analysis has been restricted to such data. With holdings-level data becoming more commonly provided, even if in a semi-transparent way through third-party platforms, risk analysis would have to be revamped to take advantage of these new data. This paper first reviews the traditional returns-based method of risk analysis and the resultant problems, and then goes on to show how the new positions-based method could help address these issues.

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