Through a Glass Darkly:  How Transparent is Hedge Fund Transparency?

Virginia Reynolds Parker, CFA
President
Parker Global Strategies

Three words in the English language characterize the nature of light filtering through a barrier, and are analogous to the levels of disclosure provided by hedge funds to their investors.  Opaque means preventing light from traveling through the barrier, leaving objects invisible.  Translucent means allowing some light through so that objects are visible, though not clear.  Transparent means being able to see through so that objects can be seen clearly.

How does this relate to hedge funds?

The bailout of Long Term Capital Management, the huge U.S.-based hedge fund noted for its secrecy, the magnitude of its failure, and the roster of Nobel Prize winning laureates among its principals, has precipitated attempts by regulators to require greater disclosure of hedge fund risks.  The regulators and the hedge fund industry use “Transparency” as the term for increased disclosure.  However, “Translucent” may be the more apt term for the current state of disclosure.

A brief history of disclosure.

Hedge funds continue to be a largely unregulated industry.  Until recently, most managers have supplied bare bones information to investors:  Sharpe ratios, number and severity of drawdown periods, standard deviation of returns, etc.  Since these statistics relay very little information about hedge fund risks they might be considered “opaque”.  Worse yet, reporting of risk information has commonly occurred just once a quarter.  This infrequency of reporting has made it difficult, if not impossible, to gauge interim risk levels.  Managers have also been able to “window-dress” portfolios for quarter-end reporting, further obscuring the risk picture. 

Under pressure from investors, and fearing regulatory controls, some managers now provide:  Value at Risk by product, leverage information, liquidity levels, limited portfolio composition, and performance attribution by asset class.  In some cases, managers have provided this information on a daily basis, although this is still rare.  Market participants refer to this as “Benign Transparency”. 

What makes this transparency benign, and not malignant?  Why don’t managers just divulge their positions?  And on a daily basis?  Two arguments emerge:  1) investors lack the skills to evaluate even “benign” information, so providing more information, such as position information, would overwhelm them or give them false comfort; 2) position information in the wrong hands hurts both manager and investor since the “dealer” community would be able to trade against this information potentially causing losses. 

Investor Skill: Does Transparency Really Help Investors?

Some investors do have the skills to understand and evaluate manager positions.  Others outsource this process to professional risk managers such as a manager-of-managers.    Either way, complete daily transparency of manager positions makes the job of analyzing risk more complicated while increasing its utility. More importantly, complete transparency facilitates the analysis of a portfolio of hedge fund investments. 

The rare investor has a single hedge fund investment.  Usually investors amass portfolios, seeking diversification.  Without complete daily transparency and the appropriate knowledge and infrastructure, risk analysis of a multi-manager portfolio is still a guessing game.  In some fund-of-funds, inadequate transparency results in too much diversification in an attempt to avoid the impact of a single manager blow-up, often resulting in lackluster performance.  Complete transparency allows the investor or its manager-of-managers to create a well diversified portfolio, and to compare actual and expected asset diversification and risk, on a daily basis.  

Like its opaque predecessor, benign transparency does little to mitigate risks such as fraud and style drift.  In the case of fraud risk, creating an infrastructure to monitor cash balances and cash transfers is paramount.  With the proper knowledge and infrastructure, investors or their manager-of-managers receiving complete transparency can ascertain risks such as fraud or style drift.  This cannot be said of a benignly transparent portfolio.  Investors or their managers-of-managers cannot prevent these risks, but they have a greater chance of uncovering them in a timely fashion if complete information is available to them.

Position Leakage:  How Well Does the Manager Know its Investors?

Trading against manager positions can harm the manager and ultimately the investor.  The question arises as to the likelihood of an investor or its manager-of-managers divulging position information to parties with the motivation or resources to squeeze a manager.  Leakage of information about a manager’s positions is more apt to occur, and to be more dangerous, because of information and rumors flowing through the dealer community than it is because of investor indiscretion.  If hedge funds know who their investors are, or who the manager-of managers for the investor is, they can determine whether they are likely to use position information improperly.  Confidentiality agreements bind investors and managers-of-managers to maintain secrecy relating to hedge fund investments.  Investors, or their manager-of-managers, should be able to hedge against risks in the portfolio or multi-manager portfolio, but should be limited to hedging versus position-taking, front-running, etc.   

What role does technology play in the drive towards transparency?

As institutional and individual investors use the Internet to keep track of their investments, electronic forms of information becomes a valuable currency.  And the hedge fund industry has used technology to make progress in responding to this investor-led desire for greater transparency. 

Technology enables a sophisticated investor, a manager-of-managers, or even a fund-of-funds manager to:

·       Gather hedge fund position data from both the manager and its Prime Broker and counterparties

·       Reconcile these positions independently, including cash positions

·       Analyze the risk of the reconciled positions using value at risk, stress testing, correlation analysis, concentration analysis, etc.

·       Calculate a daily (or real-time) NAV, incorporating estimated fees and expenses

·       Report NAV and risk information via the web in a customized and client-friendly format

·       Provide position information via the web, as needed

To date, few managers-of-managers offer this soup-to-nuts daily risk management service.  In fact, it is this risk management process that distinguishes the manager-of-managers from the fund-of-funds manager.  Certain investors have the resources and skill to maintain these technologies in-house, but most turn to an outside professional such as a manager-of-managers.   Some business models currently available stop short of providing certain aspects of this comprehensive service.  Nonetheless, the hedge fund community, pressured by both the threat of regulatory controls and technology-savvy investors, has made significant progress in addressing the need for complete transparency.
 

Parker Global Strategies, LLC

Parker Global Strategies is a Manager-of-Managers providing a broad spectrum of Alternative Investment Strategies to private and institutional investors.