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Hedge Fund Reporting Survey3392

Hedge Fund Reporting Survey3392

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Sections

  • Foreword
  • Executive Summary
  • 1. Introduction
  • 2. Background
  • 2.3 Specific Issues with Hedge Fund Performance
  • 3. Methodology and Data
  • 3.1 Methodology
  • 3.2 Data
  • 4.1 Hedge Fund Reporting: the Big Picture
  • 4.2 Key Indicators: Performance Indicators and Risk Measures
  • 4.3 Specific Hedge Fund Risks Reconsidered
  • Conclusion
  • References
  • About Newedge Global Prime Brokerage

An EDHEC Risk and Asset Management Research Centre Publication

Hedge Fund Reporting Survey
November 2008

in association with

Table of Contents
Foreword ............................................................................................................... 3 Executive Summary ............................................................................................. 5 1. Introduction ...................................................................................................13 2. Background .....................................................................................................17 2.1 Hedge Fund Reporting: Importance, Challenges, and Regulation ................................................................................................. 18 2.2 Performance and Performance Risk Measures of Hedge Funds ................................................................................................. 22 2.3 Specific Issues with Hedge Fund Performance ............................... 29 3. Methodology and Data ................................................................................35 3.1 Methodology ............................................................................................... 36 3.2 Data ................................................................................................................ 36 4. The View of the European Hedge Fund Industry on Current Disclosure Practices ................................................................39 4.1 Hedge Fund Reporting: the Big Picture ............................................ 40 4.2 Key Indicators: Performance Indicators and Risk Measures ........ 43 4.3 Specific Hedge Fund Risks Reconsidered .......................................... 48 5. Conclusion ......................................................................................................55 References ...........................................................................................................59 About the EDHEC Risk and Asset Management Research Centre .........66 About Newedge Global Prime Brokerage .................................................... 70

We are grateful to Stéphane Daul, Laurent Favre, Walter Géhin, Jean-René Giraud, Adina Grigoriu, Philippe Malaise, and Mathieu Vaissié for helpful comments. Any remaining errors are ours. Printed in France, November 2008. Copyright EDHEC 2008. The opinions expressed in this survey are those of the authors and do not necessarily reflect those of EDHEC Business School.

Hedge Fund Reporting Survey - November 2008

Foreword
Since it was set up in 2001, the EDHEC Risk and Asset Management Research Centre has monitored practices in the European asset management industry. The Centre’s surveys on the state of the industry look specifically at the use of recent research advances and at best practices. These surveys have shed light on portfolio risk management, the use of indices and benchmarks, funds of hedge fund management, ETFs, alternative diversification, and real estate investment. In particular, EDHEC published a report on funds of hedge fund reporting practices in January 2005. In that document, we made the case that improved reporting would be useful to both investors and managers, and should not be seen only as a constraint by the latter. The recent extraordinary events in financial markets are likely to increase investors’ needs for proper information disclosure. In particular, many hedge fund strategies have incurred significant losses, raising awareness of their exposure to various risk factors. Whether hedge fund managers should share information on such risk exposures with their investors, and how they should do so, is, as it happens, the focus of the EDHEC Hedge Fund Reporting Survey 2008. This survey has enabled us to compare industry practices, guidelines issued by industry bodies, and academic research into hedge fund performance and risk disclosure. The survey is divided into two parts. The first part outlines the issues with hedge fund reporting and gives a brief review of the state of the art in performance and risk analysis for hedge fund investments. The second part presents the survey’s findings on current industry practices and on the preferences expressed by investors and managers. Overall, the results suggest that investors’ requirements for hedge fund disclosure diverge considerably both from hedge fund managers’ perception of what is relevant and from guidelines and “best practices” published by industry bodies. In addition, today’s reporting still relies heavily on risk and performance measures that the academic literature has found unsuitable for hedge fund portfolios. We are grateful to the many participants who have responded to our questions and without whom this survey would not have been possible. We would also like to express our appreciation to the authors of the survey, to Amélie Jean and Lucie Liversain, who helped distribute the questionnaire, and to the publishing team led by Laurent Ringelstein. Finally, we would like to extend our most sincere thanks to our partners at Newedge Prime Brokerage, whose generous support of our research into information disclosure in the hedge fund industry has enabled this survey to be produced. We look forward to expanding our research in this area with Newedge Prime Brokerage's backing in the months and years to come, so that EDHEC can continue to provide the industry with state-of-the-art applied research.

Noël Amenc
Professor of Finance Director of the EDHEC Risk and Asset Management Research Centre

An EDHEC Risk and Asset Management Research Centre Publication

3

he was also affiliated with the Centre de Recherche en Economie et Statistique (CREST) in Paris. David obtained his PhD in economics from the University of Bonn. the predictive power of equity analysts’ forecasts. David Schroeder is a senior research engineer at the EDHEC Risk and Asset Management Research Centre. He conducts research in empirical finance and asset allocation. and decision making under ambiguity. 4 An EDHEC Risk and Asset Management Research Centre Publication .Hedge Fund Reporting Survey . He is a member of the Econometric Society and has presented at many international economic and finance conferences. His work has appeared in various international academic and practitioner journals and handbooks. His research focuses on empirical asset pricing. with a focus on alternative investments and indexing strategies. He obtained a PhD in finance from the University of Nice SophiaAntipolis after studying economics and business administration at the University of Bayreuth and EDHEC Business School.November 2008 About the authors Felix Goltz is head of applied research at the EDHEC Risk and Asset Management Research Centre. During his doctoral studies.

Executive Summary A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 5 .

The EDHEC Hedge Fund Reporting Survey is representative of the European hedge fund industry To obtain a comprehensive view of industry practices. since the action of the hedge fund management might be detected only when a fund has failed. However. managing directors. But incomplete disclosure can have some undesirable side effects. but more recently institutional investors have increased their stakes in hedge funds considerably. with assets under management of between 100mn and 10bn EUR. The survey participants are mainly medium-sized companies. liquidity and leverage risk indicators. such as appropriate performance measures. fund of hedge fund managers. The objective of this survey is to shed light on current industry practices in order to 6 An EDHEC Risk and Asset Management Research Centre Publication establish an industry benchmark for hedge fund reporting in Europe. In the past. prospects for future gains or losses are relevant to investors as well. To shed light on hedge fund reporting. the other sections address very specific topics. in part because they have to render accounts to their own investors. the EDHEC Hedge Fund Reporting Survey targets the three main professional groups of the European hedge fund business: hedge fund managers. some major firms with more than 100bn EUR in assets under management respond to the survey as well. Since many hedge funds use highly speculative investment strategies. In this light. Yet. It might open the door for hedge fund managers to change their investment strategy or to include investments in the portfolio that are riskier than provided for by the managers' mandate.November 2008 Executive Summary Like any investors. The remarkable rise of the hedge fund industry over the past decade has aggravated the problem. about half of the 214 survey respondents are high-ranking executives (CEOs. have more sophisticated investment objectives and therefore require greater disclosure. such as pension funds or insurance companies. the typical hedge fund investor was a wealthy private client. all of which are equally represented in the survey. it is clear that hedge fund reporting can be a source of tension between investors and hedge fund management. It is not only information on past investment returns that is of particular interest. and thereby reduce investors' returns. Investors even risk fraudulent behaviour. and hedge fund investors. or the difficulty of sensitive operational risk reporting.Hedge Fund Reporting Survey . fund managers fear that a thorough disclosure of their portfolio holdings would significantly decrease their chances of winning their bets. investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment. These investors. hedge funds are reluctant to provide detailed information on their investment portfolios. We present below the main results of this survey. the survey contains sections devoted to issues of particular interest to hedge funds. Moreover. CFOs). Whereas the first set of questions asks more general questions on the importance of and satisfaction with current hedge fund reporting. The quality of hedge fund reporting is an important indicator of a fund's overall excellence and thus a crucial investment criterion One of the most important findings of this survey is that the hedge fund . unlike mutual funds. and whether this allocation yields positive returns or not.

investors themselves regard this aspect as least important. Most practitioners think that the main An EDHEC Risk and Asset Management Research Centre Publication 7 . the perceived importance of information differs most about information on liquidity risk. Objectives of hedge fund reporting Next.November 2008 Executive Summary industry unambiguously believes that a fund's reporting quality is an indicator of the overall excellence of a hedge fund. we find that reporting quality is essential for investors' decisions to invest in a hedge fund. and the portfolio composition of hedge funds. As can be seen. We find that. Hedge fund managers are not aware of their clients' true information requirements The EDHEC survey reveals that hedge fund managers are not well informed of their investors' needs for information. The figure below illustrates these results by presenting the perceived importance of components of hedge fund disclosure by professional group. implying that investors wish to see much more disclosure on these issues than fund managers consider necessary. Is hedge fund reporting an important indicator for a hedge fund's overall quality? objective of hedge fund reporting is to assess the risk/return profile of the hedge fund under consideration. we examine what industry practitioners believe to be the main objectives of hedge fund reporting. investors consider much more information relevant to risk assessments of a hedge fund than do managers of the hedge funds themselves. Risk information for the investors' total asset allocation and performance attribution are also considered important objectives of hedge fund disclosure. However. this study shows that more than 70% of all investors have internal disclosure requirements that must be met before they invest in a hedge fund. In fact. risk-adjusted performance and the beta exposure of a fund. in general. they stress the relevance of information on past returns and extreme risks. operational risk.Hedge Fund Reporting Survey . When the facets of risk and performance disclosure are compared. Other great differences are apparent when it comes to the qualitative outlook. Furthermore. hedge fund managers think that information on risk-adjusted returns is relatively more important to investors.

operational risks. and the valuation framework. These missing aspects include—most important—information on a fund's liquidity risk.Hedge Fund Reporting Survey . hedge fund managers view the information they disclose much more highly than do their investors. Hedge fund managers tend to overestimate the quality of their reporting The EDHEC hedge fund reporting survey also presents evidence that many hedge fund managers overestimate the reporting quality of their funds. The scatter plot thus makes it possible to detect aspects of hedge fund reporting that are judged very important. Although hedge fund reports are perceived to provide consistent. believing that their investors are uninterested in these additional indicators. Current hedge fund disclosure practices do not meet the demands of investors. Hedge fund reporting—Wishes and reality Answers by fund of hedge fund managers and investors As a direct consequence of scarce information. As the exhibit below shows.November 2008 Executive Summary What is important for a good hedge fund report? Answers by professional group Finally. and sufficiently frequent information on past returns. clear. The gap between the managers' and investors' views of the quality of information on auditing and compliance with the fund's 8 An EDHEC Risk and Asset Management Research Centre Publication . many crucial issues of hedge fund risk are left unaddressed. we also find that hedge fund managers use many risk and performance measures without disclosing them to investors. Other topics viewed as neglected in hedge fund reporting are information on leverage risk (53% of all responding investors are dissatised with leverage risk disclosure). current hedge fund reports do not satisfy the informational requirements of investors. this divergence in the views of what information is important is an obstacle to hedge fund investment. Since hedge fund disclosure is designed to inform investors. The exhibit on the bottom of the opposite column illustrates some of the perceived shortcomings of hedge fund disclosure by opposing perceived importance with the perceived quality of aspects of hedge fund reporting. but that do not yet comply with the investors' requirements (upper left part of the plot). and factor exposure.

Whereas almost all investors consider the information contained in hedge funds is sufficient to assess the reporting quality. 2008) (Garcia and de los Rios. fund managers agree that their information disclosure on issues concerning valuation. Although academics have proposed adjustments to correct for overly smooth hedge fund returns. is not suitable for risk-adjusted hedge fund returns. 1997) (Amenc et al.Hedge Fund Reporting Survey . There are similarly divergent views on the quality of reporting in general. In short. Finally. Does hedge fund reporting provide investors with sufficient information on…? Answers by group Inappropriate risk measures. The smoothing of hedge fund returns as a result of illiquid assets is another critical point. a substantial fraction of survey respondents judge manager estimates to be a suitable way to price hard-to-value assets. they are rarely used.. since they are too crude and thus do not reflect all risks related to hedge fund investment. 2007) Should be based on factor models. However. or internal controls is insufficient. most of the funds that report factor exposure rely on standard linear factor models. In contrast. many industry participants want to see a hedge fund's alpha calculated with respect to a hedge fund index or a peer group of hedge funds.. however. these techniques are appropriate neither as benchmark nor as a means of calculating a fund's abnormal return. might induce managers to misstate the returns of their hedge funds deliberately. 2004) Alpha analysis Smooth returns due to illiquid assets About 50% prefer peer group or HF index Only 5% use return smoothing-robust measures An EDHEC Risk and Asset Management Research Centre Publication 9 . In addition. Although many empirical studies present evidence that the Sharpe ratio. The table below summarises some of these Academic Literature Non-normality of hedge fund returns Dynamic factor exposure of hedge funds problems. though empirical research has shown that non-linear factor exposures play an important role in hedge fund returns. many respondents still believe in this measure. Industry practices 62% do not know how to test for nonnormality 68% prefer Sharpe ratio 78% use linear factor models Overview: academic standards and current industry practices of hedge fund disclosure Hedge fund returns are not normally distributed (Agarwal and Naik. Likewise. 1991) Hedge fund returns are smoother than they ought to be (Getmansky et al. for example. peer groups inappropriate (Sharpe. performance indicators and reporting practices prevail in the hedge fund industry We also find that inappropriate performance measures prevail in the hedge fund industry. 2004) Linear factor models are not appropriate (Fung and Hsieh. This practice. the hedge fund industry is still beset by many inappropriate reporting practices.November 2008 Executive Summary private placement memorandum (PPM) is particularly wide. more than half the managers disagree.

A circle (o) signifies that the respective guidance mentions the corresponding issue.Hedge Fund Reporting Survey . extreme risks. and others). management. the lower panel those which are deemed less important. etc.) Operational risk o o o + o + + + + + o and professional organisations (such as the Alternative Investment Management Association. Although these guidelines are the most important information source for the hedge fund industry (see the figure opposite). they fall short of providing sufficient guidance on disclosure for hedge fund managers Information sources for good hedge fund reporting When comparing the information required by investors with the guidelines and best practices as issued by industry associations Alternative Investment Management Association (AIMA) Reporting style (consistency. A more detailed discussion of these guidelines is contained in section 2. 10 An EDHEC Risk and Asset Management Research Centre Publication . Note that the report by IOSCO is meant to cover the valuation of hedge funds only.1. a plus (+) indicates that it contains detailed advice for this kind of risk disclosure. Hedge Fund Standards Board. these best practices fall short of encouraging hedge funds to provide information on very important aspects of hedge fund risks. Guidelines for disclosure of a fund's risk-adjusted returns.November 2008 Executive Summary Although guidelines and best practices for hedge funds have a great impact on industry practices. frequency. etc. and 42 of this document.) Valuation framework Past returns Extreme risks Factor exposure Portfolio composition Leverage risk Liquidity risk Hedge fund structure (legal. they rarely provide guidance on sound hedge fund disclosure. Managed Funds Association (MFA) + o + Guidance of industry "best practices" on optimal disclosure of hedge funds Hedge Fund Standards Board (HFSB) + + o o President's Working Group (PWG) o o o o o o International Organization of Security Commissions (IOSCO) + + + + o Topic mentioned in the guideline + Detailed advice in the guideline The upper panel contains the components of hedge fund reporting deemed to be very important by investors following the analysis presented in exhibits 8. and thus have a great impact on the hedge fund industry. Hence. leverage and liquidity risk. or its factor exposure are given especially short shrift. many of these guidelines are very vague and cover topics where there is already standard disclosure. As the table below shows. 39. our study finds remarkable shortcomings. such as about the general hedge fund structure or information on past returns.

An EDHEC Risk and Asset Management Research Centre Publication 11 . in great detail. A large body of academic literature shows that many prevailing risk measures are unsuitable for reporting the true economic risks of hedge fund investment. better reporting is likely to benefit all those involved in the industry. hedge funds should move to more appropriate risk and performance measures when disclosing their returns to investors. To ensure greater hedge fund transparency. First. leverage and liquidity risk. Guidance on optimal disclosure of a fund's risk-adjusted returns. many other aspects for risk reporting could be easily improved without putting a hedge fund's investment strategy in danger.November 2008 Executive Summary Conclusion The results of this survey have a number of implications for the hedge fund industry. the portfolio composition of hedge funds.Hedge Fund Reporting Survey . but that they are not actually used. or its factor exposure is often neglected. the evidence on hedge fund reporting practices suggests that current guidelines and best practices of industry associations are unlikely to boost hedge fund transparency. The problem is not that there are no meaningful indicators. existing guidelines should be extended to cover these risks as well. and thus investor confidence. Finally. great differences between hedge fund managers' perception of relevant information disclosure and their investors' needs suggest that the industry should expand overall disclosure. It is important to note that this statement should not be misinterpreted as a call for more regulation of the hedge fund industry. extreme risks. Second. Although there might be good reasons not to disclose. Nonetheless.

Hedge Fund Reporting Survey .November 2008 Executive Summary 12 An EDHEC Risk and Asset Management Research Centre Publication .

1. Introduction A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 13 .

1 But incomplete disclosure can have some undesirable side effects. see Brunnermeier and Pedersen (2005). Although recent years have seen attempts to create standards for voluntary hedge fund reporting. since the action of the hedge fund management might be detected only when a fund has failed. such as pension funds or insurance companies. Finally. is it possible to surmount the existing barriers to hedge fund investment. investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment.The disclosure of short positions can lead to dangerous counterstrategies by competitors. in the absence of 14 An EDHEC Risk and Asset Management Research Centre Publication . The remarkable rise of the hedge fund industry over the past decade has aggravated the problem. this survey aims to compare the status quo of hedge fund reporting with recent academic advances in the literature. Only by detecting differences in the perception of hedge fund reporting on both sides of the equation.November 2008 1. Regulators such as the SEC largely agree on this view (Cox. Yet. These investors. The objective of this survey is then to describe current industry practices to establish a European benchmark for hedge fund reporting. but more recently institutional investors have increased their stakes in hedge funds considerably. these rules do not apply to hedge funds. as is the case for standard mutual funds. hedge funds are reluctant to provide detailed information on their investment portfolios. fund managers fear that a thorough disclosure of their portfolio holdings would significantly decrease the chances of winning their bets. but have also created confusion about the measures that should actually be used for hedge fund disclosure. It is our aim to bridge the gap between the theoretical arguments of financial economists and the needs of the practitioners. in part because they have to render an account to their own investors. A substantiated view on the multiple facets of hedge fund reporting is essential to a better understanding of the conflicts between hedge fund managers and their investors. In the past. it is clear that hedge fund reporting can be a source of tension between investors and hedge fund management. In many economic frameworks. which are subject to detailed disclosure rules. Investors even risk fraudulent behaviour. In this light. and whether this allocation yields positive returns or not. 2006). It might open the door for hedge fund managers to change their investment strategy or to include investments in the portfolio that are riskier than provided for by the managers' mandate. there is as yet no industry agreement on hedge fund disclosure. as it were. the results of this survey might serve as an industry benchmark for current reporting standards. leaving the conflict with the investors and managers. and thereby reduce the investors' returns. adding that such disclosure could harm market efficiency. Introduction 1 . After all. unlike mutual funds. In essence.Hedge Fund Reporting Survey . Like any investors. It is not only information on past investment returns that is of particular interest. prospects for future gains or losses are relevant to investors as well. Moreover. the typical hedge fund investor was a wealthy private client. have more sophisticated investment objectives and therefore require greater disclosure. The past ten years have seen a tremendous increase in the number of hedge fund performance and risk measures. the hedge fund industry is not regulated. Since many hedge funds use speculative investment strategies such as short selling. and consequently hedge fund reporting is not subject to legislative rules. However. such conflicts of interest are solved by government regulation. Many of these new indicators have their strong points.

This survey proceeds as follows. for example. We find that hedge fund reporting is primordial. the survey targets the three main professional groups of the hedge fund business: hedge fund managers. 92% of all industry practitioners believe that the quality of hedge fund reporting is an important signal of a fund's overall quality. the reporting quality of one's competitors can serve as a standard.November 2008 1. Investors. such as appropriate performance measures. Not surprisingly. Finally. This study also reveals that inappropriate performance measures predominate in the hedge fund industry. Whereas the first section asked more general questions on the importance of and satisfaction with current hedge fund reporting. Similarly. however. though empirical research has shown that non-linear factor exposures play an important role in hedge fund returns (Fung and Hsieh. and thus pivotal for investors' decisions about hedge fund investment. Section 2 first discusses the importance of hedge fund reporting in more detail and provides a short overview of the existing regulatory framework and reporting guidelines as issued by government working groups or 15 An EDHEC Risk and Asset Management Research Centre Publication . is unsuitable for reporting risk-adjusted hedge fund returns (Lo. for example. Hence. Although many empirical studies have shown that the Sharpe ratio. Introduction government regulation. or the difficulty of sensitive operational risk reporting. stress that hedge fund disclosure also helps to control the fund managers' behaviour. hedge fund managers think that hedge fund reporting is important to advertise their funds or to act as a fund selection tool for investors. 2000). hedge fund managers have rosier views of the quality of the information they disclose than do their investors. Finally. Likewise. investors tend to ask for the same information. many respondents still trust it. 1997. To shed light on hedge fund reporting. Although they are satisfied with the information on past hedge fund returns. most funds that indicate their factor exposure to investors rely on standard linear factor models.Hedge Fund Reporting Survey . About two-thirds mention these documents as the most important information source. it is our hope that this study can be useful for all industry participants as a source of information on appropriate hedge fund disclosure. However. Industry guidelines and codes of best practices are very influential for practitioners' opinions of optimal hedge fund disclosure. however. the information on their fund's liquidity and operational risk exposure is regarded as incomplete. Investors. The EDHEC Hedge Fund Reporting Survey was taken with the help of an online questionnaire sent to European professionals in the hedge fund industry. Fund managers. information disclosure is not viewed as adequate by investors. For a comprehensive view on current practices in the industry. 2002). consider information on extreme risks far more important. liquidity and leverage risk indicators. the survey shows that managers and investors have diverging views on the quality of current hedge fund reporting. believe that risk-adjusted returns are the most crucial performance measure. the questionnaire contained sections devoted to issues of particular interest to hedge funds. fund of hedge fund managers. the other sections addressed very specific topics. and hedge fund investors. their objectives and important components.

November 2008 1. We then summarise the most important risk and performance measures and discuss other crucial risks hedge funds are generally exposed to. The results of the EDHEC Hedge Fund Reporting Survey are found in section 4. Introduction industry associations. where we draw a comprehensive picture of the status quo of hedge fund reporting. Section 5 draws conclusions from the survey results. The survey methodology is presented in section 3.Hedge Fund Reporting Survey . 16 An EDHEC Risk and Asset Management Research Centre Publication .

Background An EDHEC Risk and Asset Management Research Centre Publication 17 .2.

and Regulation 2. In addition. Section 2. and operational risk.2 takes a closer look at the performance and risk measures used in hedge fund reporting. Challenges. 18 An EDHEC Risk and Asset Management Research Centre Publication .Hedge Fund Reporting Survey . Although some of the standard measures are widely used. if the rare event occurs. In the remainder of this section.November 2008 2. The complexity of hedge fund investments poses a challenge for analysis as required by adequate and comprehensive disclosure of returns. others are of a much more qualitative nature and thus harder to formalise. We outline the major challenges for hedge fund reporting and review the tools available to report performance and the risks of hedge fund investments. as well as guidelines and best practices issued by government working groups and industry associations. liquidity. Finally. and consequently his fund will yield a rather high rate of return—obtained from selling the options and the interest gained on the proceeds.1. Foster and Young (2008b) show why detailed hedge fund reporting is indispensable—and difficult to achieve at the same time. Unlike mutual funds. If he is lucky. the existing regulatory framework. In contrast.2 Then he invests the money obtained from selling the options and the collected hedge fund capital in treasury bonds—and does nothing. the rare event does not occur over the lifetime of the option. they can engage in short selling of securities and use leverage. Background 2 . such as leverage.Such an event can be a decline of the S&P500 by more than 20% in one year. Although some of the key elements of hedge fund reporting can—in principle—easily be captured by appropriate indicators. They consider a hedge fund manager who sells options that pay their holders a specific amount of money in the event of a rare event. First. section 2. Consequently.1 Hedge Fund Reporting: Importance. 2. section 2. The example raises the question of the possible means of increasing the confidence of hedge fund investors. investors incur a heavy loss.1 Motivation and challenges of hedge fund reporting In an illustrative example.3 examines specific issues that are of particular importance for hedge fund disclosure. we describe some of the means of reducing informational asymmetries between investors and hedge fund managers. This section serves as theoretical background to the EDHEC Hedge Fund Reporting Survey. This hypothetical example makes clear why good hedge fund reporting is difficult: the mere disclosure of past returns may not be sufficient to reflect the underlying risk of a portfolio.1 demonstrates both the importance and the challenges of hedge fund reporting. even the more detailed risk reporting might not be helpful for investors: managers can in principle just add some noise trading to their major investment strategy to disguise the underlying bets. In addition. hedge funds use dynamic investment strategies and enjoy a high degree of freedom with respect to the instruments that they can hold in their portfolios. they are not always suitable from a theoretical standpoint. alternative strategies are infinitely more complex than those of traditional funds.

many of the hedge fund performance measures can be gamed by managers. The managed account platform can thus provide investors with the required information. Unlike return-based reporting. return-based hedge fund reporting is only backward looking.Hedge Fund Reporting Survey . they are rarely used. holdingsbased reporting attempts to disclose the current holdings of hedge funds—which might. which can then be forwarded to investors. When key figures about past hedge fund performance. Thus. We return to this reporting style in section 2.3. Do et al. but merely to calculate the risk and performance measures of the fund.3. generate managerial opposition. also called return-based reporting. Another option is to rely on external platforms not to manage the hedge fund itself. even very detailed reporting cannot entirely resolve the problems of hedge fund opaqueness. Next. and accurate hedge fund reporting. consistent. thereby improving and complicating things at the same time. Auditing and external platforms Another means of building trust between hedge funds and their investors is to include independent third parties in the reporting process. smooth returns may be a sign that a manager is gaming performance measures. On the other hand. Examples of such techniques are provided by Goetzmann et al. hedge funds can 19 An EDHEC Risk and Asset Management Research Centre Publication . Although Goetzmann et al. (2007) also propose performance measures that are manipulation-proof. Reported returns of hedge funds are often much smoother than their true returns.November 2008 2. however. are provided. a hedge fund can decide to let its reports be audited by a third party.2). Background Detailed reporting The most important means of reducing asymmetries of information between hedge fund management and investors is detailed. However.2. One possibility is to run the hedge fund via a managed account which then carries out the trading activity as directed by the hedge fund manager. (2005) point out that traditional measures. Eling and Schumacher (2007) argue that many of the proposed performance measures lead to highly correlated rankings of hedge funds. All information contained in hedge fund reports therefore contains valuable prospective information only when it is assumed that the future investment strategy and the investment environment will remain unchanged. can be very misleading when evaluating hedge funds. A potential solution to the problems related to the disclosure of past returns is so-called holdings-based reporting. The rapidly changing strategies of hedge fund managers and occurrences of spectacular hedge fund closures following sudden changes in the markets prove that these assumptions are often untenable (even if the manager has positive intentions). Finally. A comprehensive description of the most important performance and risk indicators is provided below (section 2. Another problem is the abundance of the proposed performance and risk measures. First. Academics constantly propose new indicators. Bringing in such outside parties to validate the reported figures can take place at different stages. (2007). such as the Sharpe ratio. empirical evidence is provided by Bollen and Pool (2007). Besides these external devices. investors have a comprehensive picture of the past risks and returns of their stakes.3. This issue is discussed in more detail in section 2.

Finally. to achieve greater reporting transparency. the FSA has decided to use a principle-based regulation instead of creating rules that specify exactly what is permitted or prohibited. Background also opt to implement internal controls. In the UK. Since the involvement of third parties is seen as a very important step to reduce operational risk. without delivering any investment skill. Liang (2003) shows that audited funds have more coherent data in hedge fund databases. which can be interpreted as a sign of greater reporting reliability.2 Existing regulation of hedge fund disclosure Although hedge fund disclosure is largely unregulated.g. Since the investment strategies used by hedge fund managers evolve very quickly.6. We turn to this issue in the following sections. The involvement of third parties or internal controls is. Hedge fund fee structure The complex fee structure of hedge funds. Although fees mitigate the conflict of interests to some extent. with high performance fees and high water marks. To sum up. hedge funds are subject to government regulations in many countries. unskilled managers may successfully mimic the behaviour of good managers over a certain time period and thus earn high fees. However. auditing sometimes has trouble in keeping up. regulators or industry associations can play a role in creating generally accepted reporting standards. no guarantee of the correctness of a report—it is only a step in that direction. despite the many cited problems and caveats. there are conflicts of interest between hedge funds and the auditing firm. but detailed information on the hedge fund performance audited by an independent third party seems to be a reasonable solution for investors. such as delegating the determination of a funds' net asset value to an independent administrator. Foster and Young (2008a) show that it is generally impossible to design an incentive scheme that makes it possible to distinguish between skilled managers and unskilled managers (including the 20 An EDHEC Risk and Asset Management Research Centre Publication . fraudulent manager of the introductory example). As with any third party audit. Any hedge fund reporting system will have its drawbacks. FASB 157). which can lead to suboptimal audit quality. the FASB statement 107 (Disclosures about Fair Values of Financial Instruments) imposes some regulations. we come back to this issue in section 2. Hence. this is not so. Unfortunately. however.Hedge Fund Reporting Survey . hedge fund reporting remains the only sensible way to reduce information asymmetries and thus to create investor condence. 2. Nevertheless. Many of the standards are concerned with valuation principles and thus do not affect hedge fund disclosure itself (e.1. In the light of the impossibility theorem. the fee structure of hedge funds does not seem to be a feasible means of increasing investor confidence.November 2008 2. Hedge funds that are registered in the US must comply with the country's generally accepted accounting principles (US GAAP). auditing seems to have some positive effects on reporting quality. Another drawback of hedge fund auditing is the great expertise required of auditing firms. might lead to the conclusion that hedge fund managers' fee structures are designed to align the interest of managers and investors.3..

Organisation PWGa PWG MFAb AIMAc OICV-IOSCOd AIMA HFSB/HFWGe 3 . such as the AIMA Australia. but give a rather broad overview of what the hedge fund management should do to improve the governance of a fund. there have been many attempts to impose "best practices" or "sound guidelines" on the hedge fund industry. such as those of the Risk Standards Working Group. Date 2008 2008 2007 2007 2007 2007 2008 Region US US US Europe International UK UK Name Best Practices for the Hedge Fund Industry Asset Managers' Committee Best Practices for the Hedge Fund Industry Investors' Committee Sound Practices for Hedge Fund Managers Guide to Sound Practices for Hedge Fund Managers Principles for the Valuation of Hedge Fund Portfolios Guide to Sound Practices for Hedge Fund Valuation 28 Best Practice Standards Content Overarching guidelines for asset managers Overarching guidelines for hedge fund investors Overarching guidelines for asset managers Overarching guidelines for asset managers Hedge fund valuation Hedge fund valuation Overarching guidelines for asset managers Note that this list includes only the most important best practices and guidelines. or the FSA Dubai.3 Reporting guidelines Besides existing government regulation. In addition. Background Also. aPresident's Working Group on Financial Markets bManaged Funds Association cAlternative Investment Management Association dInternational Organization of Securities Commissions eHedge Fund Standards Board/Hedge Fund Working Group An EDHEC Risk and Asset Management Research Centre Publication 21 . The sections on hedge fund disclosure are particularly vague and deal mainly with the general set up of hedge funds. Many other countries have their own guidelines. In Europe. Table 1 provides an overview of the most important guidelines for hedge funds. as displayed in table 2. often with the aim of reducing systematic risks in financial markets by encouraging better hedge fund governance and detailed hedge fund reporting standards.Hedge Fund Reporting Survey . the multitude of guidelines is a challenge for hedge fund managers. rejected the European Parliament's 2008 attempts to increase hedge fund regulation in Europe. many regulations deal with aspects other than information disclosure. Minimum compliance with such recommendations is unlikely to give substantial help to investors. 2. associations of national hedge fund managers and industry initiatives have proposed best practice guidelines to Table 1: Best practices and guidelines for hedge funds prevent further government regulation of the industry and to make things more difficult for the industry's black sheep. the CFA. in 2006. arguing instead for self-regulation of the industry.In 2004. Charlie McCreevy.3 A detailed overview of hedge fund regulation in other European countries has been made available by the European Fund and Asset Management Association (2005). Moreover. the SEC designed a new rule that would have required hedge fund managers to register as investment advisors and disclose many critical issues about hedge fund governance. More recent attempts to regulate hedge fund disclosure in the US and the European Union have failed. Some of these attempts have been made by government organisations and financial authorities. the US Court of Appeals overturned the rule. Many of the best practices are of a very general nature.1. since some of the points addressed in the best practices might be in conflict with each other. In addition. there are other standards for risk management practices that are not specifically designed for hedge funds. However. and remain very undemanding. the European Commissioner for Internal Market and Services. as Naik (2007) points out.November 2008 2. They do not spell out rules for hedge fund managers. or the Investor Risk Committee.

he has a preference for high returns. including fees and redemption rights Disclosure of past hedge fund performance at regular intervals Detailed description of the valuation framework reflecting differences in market practices in the US and Europe. others. but also about the related risks he bears. All risk and performance risk measures thus attempt to satisfy the investor's needs to be informed about the returns. either by government regulation or by industry standards. The Hedge Fund Working Group's (HFWG) Best Standards. like return analysis..Hedge Fund Reporting Survey . such as extreme risk analysis. use of leverage. regional exposure Names and vita of the hedge fund management Managers running several hedge funds Disclosure on side letters and parallel managed accounts Hedge fund structure. Fund managers will appreciate a set of clear and simple rules that they can expect to satisfy authorities and investors across the globe. regulators benefit from a unified disclosure framework. can have many advantages. allowing them to better assess the overall risks involved in hedge fund investments. Investors are better informed.November 2008 2. The newly issued best practices of the Presidents Working Group (PWG) are completely voluntarily. are equally well informed—thereby eliminating the advantages privileged investors have at the expense of others. major hedge fund organisations set up an internet site where different guidelines can easily be compared. Clear rules for hedge fund disclosure. try to capture the riskiness of the hedge fund investment. focus on the return component. the Global Investment Performance Standards (GIPS) announced that they would extend their framework to include hedge funds by 2010. by contrast. meaning that noncomplying funds are expected to explain why they are not doing so. 22 An EDHEC Risk and Asset Management Research Centre Publication . 2. However. But most sets of guidelines are similar.e. it is not clear whether and how this practice could be enforced. Likewise.In October 2008. but dislikes the risk related to his investment. and more important.4 4 . the aim being merely to create a benchmark for hedge fund managers. attempt to establish a "comply or explain" practice. permissible investment. Another difference between the various best practice standards is the enforcement of these standards. This overview is available at: www. Some measures. Background Table 2: Common standards for hedge fund disclosure Requirement PPM Counterparties Strategy of the fund Key management Conflicts of interest Conflicts between investors Legal framework Timely disclosure Valuation framework Description/Example Existence of a private placement memorandum Disclosure of counterparties and third parties on request Style. Last year. The future is likely to see more guidelines on valuation and disclosure for hedge fund managers. hedgefundmatrix. It is to be hoped that existing and new proposals will converge over time to an internationally accepted standard.com. the typical hedge fund investor is risk-averse. so compliance with one set often implies compliance with the others. i.2 Performance and Performance Risk Measures of Hedge Funds Like any investor.

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2. Background

Finally, risk-adjusted performance measures and factor analysis combine both dimensions of any investment by relating return and risk to each other. The literature on stocks and mutual funds has proposed an abundance of measures that can be used to measure the risk and return of these investments. The crucial question is whether these risk indicators can be similarly used for hedge fund portfolios. The first works to analyse hedge fund risk and performance, including the papers by Elton, et al . (1987), Brown, et al. (1999), and Ackermann, et al. (1999), draw on these standard measures to determine whether hedge funds perform better than the market or not. However, as subsequent works by Agarwal and Naik (2000c), Fung and Hsieh (2001), Lo et al. (2001, 2002) have shown, hedge funds exhibit some particularities that make them very different from standard equity investments. First, hedge fund returns— as opposed to mutual fund returns— are not normally distributed. Second, they are non-linear with respect to the standard market factors, such as equity and bond markets. Indeed, hedge funds often modify their investment style so that their exposure to risk factors is highly dynamic over time. These differences make the standard risk and return indicators—although still widely used—inappropriate for hedge funds. In this section, we briefly describe the most important performance and performance risk indicators used in hedge fund reporting. Lhabitant (2004), Amenc, et al. (2005) and Géhin (2006) provide more comprehensive surveys on most of the

measures currently used by hedge funds. Le Sourd (2007) reviews the measures aimed at traditional investment universes, but used by hedge funds as well. 2.2.1 Analysis of hedge fund returns An initial assessment of hedge fund returns usually involves the analysis of past hedge fund returns using descriptive statistics and statistical tests. Simple to calculate, it is the basis of any hedge fund reporting and is by far the most informative to investors.

5 - The calculation of past returns is not as simple as it seems, since it is preceded by the determination of the hedge funds' value, an issue which is tackled again in section 2.3.6. Moreover, there are several ways to calculate the returns. For more detail, see chapter 2 of Lhabitant (2004).

Returns, return persistence, and volatility Past hedge fund returns are without doubt important information. Standard presentations include monthly and annual returns—net of fees—in absolute terms, and relative to a benchmark.5 Since investors are less concerned with past returns than with future returns, persistence measures are important as well. Gain frequency, calculated as the percentage of positive monthly returns is an initial indicator of performance persistence. Closely related, but more complicated to calculate, is the Hurst (1951) coefficient. Finally, the volatility of monthly returns is an initial assessment of the riskiness of the hedge fund. Simpler, but equally informative measures of a hedge fund's volatility are minimum and maximum past monthly returns, or—more generally—their upper and lower deciles (or quartiles). Downside risk There are also some key figures that help to assess the downside risk of returns—an issue of particular interest to hedge fund investors. The maximum past drawdown
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2. Background

is a simple but informative indicator of downside risk. The skewness and kurtosis of fund returns are together important in assessing downside risk: a return distribution that is negatively skewed combined with positive (excess) kurtosis is a strong indicator of high downside risk. Semi-deviation and other lower partial moments of hedge fund returns are similarly useful. Finally, hedge fund returns during extremely negative equity markets are a good measure of a fund's ability to hedge downside stock market movements.

measures underestimate a fund's riskiness. It is therefore crucial to assess the hedge fund's risk of extremely negative returns.

Non-normality and autocorrelation of hedge fund returns Information can also be had by applying statistical tests to the hedge fund returns. Statistical tests, such as the Jarque-Bera test (Jarque and Bera, 1980), make it possible to assess the normality of hedge fund returns. If normality is rejected, the fund is likely to exhibit a larger downside risk than standard equity investments. Tests of autocorrelation, such as the Ljung-Box test (Ljung and Box, 1978), are generally used to detect the fraction of illiquid assets in the hedge fund portfolio. If the test of no autocorrelation is rejected, the portfolio is likely to contain a large fraction of illiquid and thus hard-tovalue assets. Consequently, return figures must be treated with caution. Since both issues are of special interest for hedge fund reporting, we come back to them in sections 2.3.1 and 2.3.2.
2.2.2 Extreme risk measures Because of their non-normal return structure and thus higher relatively higher downside risk, simple volatility

VaR and related measures. Value-at-Risk (VaR) is perhaps the most important extreme risk measure. The VaR of a portfolio is the maximum amount of capital that can be expected to be lost within a specific time period (usually one month), given a specified confidence level (usually 95% or 99%). There are several ways to calculate VaR. The simplest is to assume a normal distribution of returns, which must be estimated to calculate the expected maximum loss. Since hedge fund returns are usually not normally distributed, an alternative is to use non-parametric estimation based on the historical distribution of hedge fund returns. In this way, the non-normality is captured automatically. Another approach uses Monte-Carlo simulation techniques to estimate the expected maximum loss. Such simulations can assume either normally distributed returns or more complex distributions that account for the asymmetry and fat tails of hedge fund returns.
Besides the standard VaR, there are more sophisticated VaR measures that attempt to meet the needs of hedge fund reporting. The so-called Cornish-Fisher VaR (Favre and Ranaldo, 2002)—also called modified VaR (MVaR)—is an extension of the standard VaR that incorporates the effect of skewness and the fat tails of hedge fund returns. Incremental VaR (Jorion, 2001) attempts to measure the change in VaR when a particular asset class is introduced to the portfolio. Closely

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6 - Strictly speaking, conditional VaR and expected shortfall are two different concepts. Conditional VaR calculates the expected shortfall given a pre-specified condence level, whereas the expected shortfall can also be calculated using another loss limit. 7 - See section 2.2.4 for more details on style analysis 8 - This is an important difference to the general notion of liquidity risk, which usually denotes the liquidity risk within the hedge fund. 9 - See Jorion (2001) for a detailed review of stress testing.

related, component VaR, described by Jorion (2001), indicates the contribution of a specific asset to the VaR of the overall portfolio. Conditional VaR (also called expected shortfall) is another extension of the VaR approach. Compared to the VaR, it does not specify the maximum expected loss for a specific confidence level, but the average amount of loss if that significant loss actually occurs. Conditional VaR is thus very important if the distribution of returns has very fat tails, since the loss might be much larger than that specified by VaR.6 Applications of the conditional VaR to hedge funds are by Agarwal and Naik (2004) and De Souza and Gokcan (2004). Finally, shortfall probability can be considered the inverse of VaR: instead of estimating the maximum loss given a confidence interval, the shortfall probability indicates the probability that a given loss will actually to occur. Another method of calculating a VaR estimate relies on style analysis, the socalled style VaR (Lhabitant 2001, 2004). This method first examines the relationships of the investment styles in the portfolio,7 then analyses the impact of the worst variation of each style on the portfolio. Laporte (2003) proposes an extension of the style VaR to include liquidity risk borne by hedge fund investors through lock-up constraints.8 By adding an additional factor to the style VaR, this model facilitates analysis of the impact of such clauses on a fund's VaR. Finally, it is important to mention the extreme value theory (EVT)(Embrecht et al., 2008; Lhabitant, 2004). Actually, it is not a variant of VaR, but an important tool to calculate it. EVT simply focuses on the modelling of the tails of a distribution,

leaving the rest unspecified. However, since rare negative events are of great importance for hedge funds, this tool makes it possible to evaluate the risks related to such events. The distribution of the tail can then be used to estimate the VaR.

Stress tests Besides the different VaR approaches, hedge funds often use stress tests to assess extreme risks. Unlike the VaR, stress testing requires no assumptions on a fund's return probability distribution and is therefore essentially a non-statistical risk measure. It relies instead on MonteCarlo techniques to evaluate the impact of extreme but probable situations on hedge fund performance. The crucial difference from VaR and EVT is the stress test's ability to simulate shocks that have never occurred in the past, or which are more likely to occur than historical evidence suggests. Stress tests can also be used to analyse the impact of structural shocks to the financial system on hedge fund returns. The basic idea of stress tests is simple: evaluating the impact of sudden changes in the determinants of hedge fund returns on their performance. Such stress tests can simulate either the consequences of changes in one particular key variable (also called sensitivity testing) on hedge fund performance or the impact of an extreme variation in many critical factors (called multidimensional scenario analysis). Stress tests can simply assume a one-shot deviation from the variables under consideration or they can involve more complicated models that reflect the impact of so-called spiral effects (second round effects) on hedge fund performance.9
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Consequently. where the beta is calculated on the basis of the CAPM (Sharpe. owing its name to the authors 26 An EDHEC Risk and Asset Management Research Centre Publication Modigliani and Modigliani (1997). They suggest adjusting the portfolio to have the same risk as the benchmark before comparing them. it captures the fact that managers often try to outperform a benchmark. however. which has been proposed by Gregoriou and Gueyie (2003). including the portfolio's sensitivities to more than one factor (Hübner.2. the socalled information ratio (IR). The advantage of the Treynor ratio is that it focuses only on the systematic component of risk. a generalisation of the Treynor ratio has been proposed. Sharpe ratio and related measures. In fact. 1965). The real challenge is to deliver good performance while limiting risk exposure. The M2 is hence equivalent to the return the fund would have achieved if it had had the same risk as the benchmark. which divides the expected excess return of a portfolio by its beta. Although the Sharpe ratio is easy to calculate and in widespread use. also called return over VaR. The Sharpe (1966) ratio is the most famous measure of return to risk. often the market index. 1964. It is the ratio of the portfolio's excess return over that of another portfolio (usually a benchmark) and the standard deviation of the return difference between both portfolios. Closely related to the Sharpe ratio is the Treynor (1965) ratio. In essence.rf and its standard deviation σp: (1) The higher the Sharpe ratio. not on total risk. it can be interpreted as a fund's excess return per unit of risk. Background 2. The modified Sharpe ratio replaces the standard deviation in the denominator of the .Hedge Fund Reporting Survey . Sharpe (1994) proposed a generalisation of his original ratio. it is inappropriate for measuring hedge fund performance. It is the ratio of the portfolio's expected excess return over the risk-free rate E[rp] .2 and 2.1 present measures to analyse both hedge fund returns and their related risks. since it assumes normally distributed fund returns—an assumption that rarely bears out. 2005). the better the risk-return trade-off. because above-average returns are not a surprise when running high-risk strategies. apart from slight modications. while maintaining a low tracking error. the Sortino ratio is more appropriate for hedge funds. Risk-adjusted performance measures are designed to detect investments that have a good risk/return trade-off. it is equal to the Sharpe ratio times the standard deviation of the benchmark. Along with the evolution of multi-factor models.2.3 Risk-adjusted performance measures Sections 2. all risk-adjusted performance measures follow this principle by relating returns to units of risk. such as the Fama and French (1992. Intuitively. Another variant of the Sharpe ratio is the modified Sharpe ratio. Lintner. Thus. The Sortino ratio (Sortino and Price. The M2 measure. The most interesting parts of hedge fund reporting. also focuses on how to evaluate performance compared to a benchmark. 1994) offers a slightly different measure by replacing the standard deviation with the downside deviation. are indicators that combine both analyses. Almost three decades after the Sharpe ratio.November 2008 2.2. 1993) three-factor model.

However. the projection of expected returns and drawdowns can be cumbersome. The Omega ratio has been put forward by Keating and Shadwick (2002). since some funds provide high returns only by bearing extremely high drawdown risk. Two conceptually simple ratios to determine return relative to downside risk are the Calmar and Sterling ratios.Hedge Fund Reporting Survey . the aim is to capture downside risk (captured by the maximum drawdown). they neglect a crucial part of risk-return considerations: the source of hedge fund returns and their related risks.2. Although easily calculated for past returns. In an attempt to create a measure that combines the positive aspects of the Omega ratio (reflecting higher moments) and the Sharpe ratio (easy interpretation). Based on a constant relative risk aversion utility function. Again. Its advantage is that it also includes its third and fourth moment while requiring no assumption on a fund's return distribution. the alternative investment risk adjusted performance (AIRAP) measure by Sharma (2004) is an indicator that incorporates an individual risk-aversion parameter when comparing hedge fund performance. Hence.4 Beta or correlation analysis: factor models All previous indicators focus on measuring the risk-adjusted performance of hedge fund returns. Kazemi et al. 1996) is closely related to the Calmar ratio. it also makes it possible to capture the effect of the third and fourth moments of hedge fund returns on an investor's expected utility. Besides the Sharpe ratio and modifications thereof. Background Sharpe ratio with the above-mentioned modified VaR (or Cornish-Fisher VaR). who are assumed to seek to minimise the probability that the return of their investment will be negative over a long time horizon. It is the ratio of the average annualised excess return to the average maximum drawdown per year over the last three years minus (an arbitrary) 10%. the higher the Omega. 1991) is the annual average (expected or past) excess return divided by the maximum drawdown. it uses the expected excess return in the numerator of the ratio—similar to the Sharpe ratio. The Sterling ratio (Kestner. the Stutzer index punishes hedge funds with strongly negative skewness and high kurtosis. This replacement is motivated by the fact that the MVaR takes the skewness and kurtosis of the return distribution into account. The Stutzer (2000) index tries to capture a behaviourial element of investors. The aim of beta or correlation analysis is to detect a fund's underlying return drivers by explaining the hedge fund returns through the fund's exposure 27 An EDHEC Risk and Asset Management Research Centre Publication . some other risk-adjusted performance measures are explicitly tailored for the non-normal distribution of hedge fund returns. 2. While identical in terms of ranking to the Omega ratio. The Calmar ratio (Young. Compared to the previous ratios. The Omega is a relative gainto-loss function using an exogenously (and arbitrary) return threshold. The Omega is then the quotient of the (expected) excess return over a threshold and the expected loss below the same threshold. Other risk-adjusted performance measures.November 2008 2. the better. (2004) propose a SharpeOmega ratio. Since a great likelihood of severe losses increases the likelihood of negative excess returns.

2000. which cannot be captured by simple equity factor models. Instead of using factors in the linear . 2000a). 1992). Another well-known variant of 28 An EDHEC Risk and Asset Management Research Centre Publication Non-linear and dynamic factor models. Background to various risk factors. these linear factor models using standard asset classes as factors tend to have poor explanatory power when it comes to analysing hedge fund returns. In addition. proposed by Fung and Hsieh (1997) is to include in the set of factors the returns of other asset classes. and the differences in the returns of past winners compared to past losers. They include the return spreads between value and growth stocks. 2000c. equities). Although very popular for traditional investment universes. the linear factor model is the so-called mutual fund style analysis by Sharpe (1988. α its abnormal performance. 1993) and Carhart (1997). Lintner. Hence.Hedge Fund Reporting Survey . 2001). The primary reason for this relative impotence is the non-linear and non-normal structure of hedge fund returns (Fung and Hsieh. The most prominent model is the CAPM (Sharpe. This variant accounts for portfolio returns by benchmark returns of different standard asset classes (bills. thereby attributing the portfolio returns to different investment styles or categories. which uses the return of the market portfolio as single factor to account for portfolio returns. Agarwal and Naik. small and big stocks. several extensions or adaptations of previous models have been proposed. An initial approach. Fung and Hsieh. these additional factors then capture the nonlinear and dynamic trading strategies as used by hedge funds in the linear factor model. not only a hedge fund's specific risks. bonds. Most factor models used to analyse hedge fund returns are linear models: (2) where rt is the monthly return of the hedge fund. comparisons of hedge funds are simplified. Pension funds or insurance companies must monitor their overall portfolio risk. 1965). who use equity option portfolios as factors in their model to account for non-linearities. 2000b. such as commodities (Agarwal and Naik. 2001). βk the sensitivity of the hedge fund to the risk factor k. since they are commonly used. 2004). Factor analysis is especially important for investors who consider hedge fund investment only as a part of their overall portfolio. the aim is to be more suitable for hedge fund factor analysis. exchange rates (Agarwal and Naik. and εt the disturbance term.t the return of risk factor k.November 2008 2. or hedge fund indices (Lhabitant. Fund of hedge fund investors are in the same situation when they make decisions to allocate assets to funds. Linear factor models. Most famous factor models try to explain portfolio returns by stock return factors. The primary advantage of linear models is their simplicity: their calculation is straightforward and easy to understand. 1964. Also called hedge fund style analysis. Three— and four-factor extensions are by Fama and French (1992. Fung and Hsieh. such as institutional investors. A second possibility has been proposed by Agarwal and Naik (2000c). Fk.

Background 10 . hedge funds are not log-normally distributed. 2006) or explicitly model the time-varying structure of a hedge fund's risk exposure (Berk et al. Alpha analysis is the flip side of beta analysis. 2 0 0 3 . there are many ways to model these non-linearities: higher moment adjusted models of the CAPM (Favre and Ranaldo. which is in fact an adaptation of the KolmogorovSmirnov test. How can this be? Essentially. the Sortino ratio is a good improvement over the Sharpe (1966) ratio.11 This has considerable An EDHEC Risk and Asset Management Research Centre Publication . 11 . alpha can be calculated with any of the factor models outlined above— and the value of alpha depends very much on the chosen estimation method. Xu et al . since it reflects (positive) returns without risk. 2007). or regimeswitching models (Billio et al. there are two main reasons for these so-called smooth returns: investment in illiquid assets and deliberate cheating.3. 2. Again. given their risk exposure. 2002. Since hedge funds often invest in illiquid assets. 2006). see Lhabitant (2004). For example. many adjustments of standard risk measures have been proposed to account for the non-normality of hedge fund returns. more important. 1980). it is not 29 Alpha analysis. It is also important to mention that the returns of stocks and mutual funds are not normally distributed either.3 Specific Issues with Hedge Fund Performance 2.e. 2 004). In fact. Kazemi and Schneeweiss. truly dynamic models either use Kalman lter techniques to incorporate the dynamic betas of hedge funds (Posthuma and van der Sluis. 2005. smoother than they ought to be. it is often classified as a risk-adjusted performance measure. Swinkels and Van Der Sluis. i. The same applies to all Value-at-Risk measures that assume normally distributed returns. Zhang. see section 2..2.Since the main purpose of alpha analysis is to calculate risk-adjusted returns.3. Accordingly.Strictly speaking. and the Cornish-Fisher VaR a suitable extension of standard Value-at-Risk measures. .November 2008 2. but the normality assumption is less violated compared to hedge fund returns. As presented in section 2. Alpha is basically what investors most prefer. which are based on the normality assumption. hedge fund returns are generally not normally distributed.3. consequences on a number of hedge fund risk measures. it is simply the intercept of the factor model presented in (2): the residual or abnormal return that cannot be explained by the fund's risk exposure.1 Non-normality of hedge fund returns Unlike the returns of common stocks and mutual funds. an alternative is to model the non-linearity or dynamics in the estimation. However. Another popular test is the Lilliefors (1967) test. 2004). as presented in the last sections.. Hence. such as the Sharpe (1966) ratio. Non-normality of hedge fund returns is seen easily with statistical tests for normality. are then not valid for assessing the performance and riskiness of a hedge fund. The most well-known test is the above-mentioned Jarque-Bera test (Jarque and Bera. their log returns are not normally distributed. model that exhibit non-linear features. often this distinction is not made. conditional regression models (Kat and Miffre.2.10 2. Finally.Hedge Fund Reporting Survey . Simple measures..2 Smoothed hedge fund returns Another particularity of hedge fund returns is that they are smoother than the returns of mutual funds or common stocks — and. it is most important to be aware of a hedge fund's non-normality— the suitable tools to analyse its returns are often straightforward. 1999.

Getmansky et al. can be detected by serial correlation in hedge fund returns. Getmansky et al.2 share a reliance. for example. Second. Or there might be various quotes for thinly traded securities.. In fact. Return smoothing. Returns may also be deliberately smoothed by hedge fund managers so their fund will appear less volatile than it is. it is also possible to construct risk measures that overcome this problem. Most of all. propose adjustments to the standard Sharpe ratio that correct for the bias caused by illiquid assets in hedge fund portfolios. In contrast to this so-called returnbased risk reporting. They find that for some funds the most likely reason for return smoothing is simply fraud. In contrast. which then allows investors to analyse each of the securities that make up the whole portfolio. Holdings-based reporting thus has many advantages. there is empirical evidence that hedge fund returns are too smooth. and the manager linearly extrapolates the price between two observable prices. in one way or the other.e. holdings-based reporting takes a completely different approach. i.. by definition. As a direct consequence. Bollen and Pool (2006) develop a model that makes it possible to detect deliberate cheating in hedge fund returns. First. Sometimes. Smoothed hedge fund returns and smoothed return data have considerable consequences for the evaluation of hedge funds. Background always easy to determine the net asset value of the funds. The returns thus obtained will usually be much flatter than those of similarly risky but liquid investments. as a direct consequence. it is biased downwards (Asness et al. Risk-adjusted performance measures relate past returns to past risk exposure. Holdings-based reporting is in fact a bottom-up approach. The individual risks are then aggregated over the entire fund to obtain the fund's overall risk exposure. It consists of disclosing the exact portfolio composition of a fund. deliberate or not. In principle. factor analysis explains the sources of past returns by some common risk factors. (2004) propose an econometric model of the illiquidity exposure of hedge funds and show that illiquidity is the major reason for the smoothing of hedge fund returns. Holdings-based reporting enables investors to choose their own technique for aggregating the risk of different asset or security classes and 30 An EDHEC Risk and Asset Management Research Centre Publication .3 Holdings-based reporting All the risk measures discussed in section 2.3. on past return data.Hedge Fund Reporting Survey . (2004). 2.November 2008 2. A simple test is the abovementioned test of autocorrelation by Ljung and Box (1978). the funds' volatility does not reflect its true riskiness. thereby achieving higher Sharpe ratios. risk-adjusted performance measures are no longer accurate and might even be meaningless. there are no market prices for securities available. it thereby avoids the estimation errors inherent to returnbased reporting. it allows a much more detailed analysis of all the risks involved. so the manager is inclined to use smoothed broker-dealer quotes. 2001). the managers misreport return figures to reduce the volatility of the fund's returns.

such that the risk profile reflects only earlier positions taken by the fund.4 Liquidity risk indicators Investment in illiquid assets not only causes return smoothing. Whereas asset liquidity is much more of an asset management task. liquidity risk is much more of a problem for hedge funds than for mutual funds. For this reason. the returns of a portfolio containing illiquid assets are more likely to be autocorrelated (Getmansky et al. 1978) of autocorrelation of hedge fund returns is a practical test for evaluating to what extent the fund contains illiquid assets. it is easy to draw mistaken conclusions. but is also a source of risk on its own. Liquidity problems can quickly increase the risk of fund failure. although the estimation of such liquidation periods is not straightforward. Funding liquidity risk is the risk of being unable to meet financial obligations when they fall due.Hedge Fund Reporting Survey . not clearly defined. funding liquidity has more to do with cash management.12 Asset liquidity risk measures attempt to indicate the liquidity of the assets in the portfolio. Average liquidation periods for a specified part of the portfolio are also a good measure of the liquidity risk of a portfolio. 2. only the holdings of the security classes are made public. Background thus to reflect individual risk preferences. when unwinding large 31 12 . Although the two kinds of risk are closely related. we describe the two main versions of liquidity risk and liquidity risk measures: asset liquidity risk and funding liquidity risk.e. In short. i. unfortunately. Holdings-based reporting also requires substantial data processing.3. the distinction is important. holdings-based reporting is essentially a very good concept. In this section. hedge funds publish their portfolio composition with a time-lag. 2004). as risk analysis is left to the investor.. Liquidity and liquidity risk are. The Ljung-Box test (Ljung and Box. holdingsbased reporting for hedge funds cannot be too detailed. In addition. but also the exact risk characteristics and risk classication of each of the holdings involved. The percentage of hard-to-value (non-marketable or illiquid) assets is another convenient asset liquidity risk indicator. holdings-based reporting reduces the problems related to the lack of transparency of hedge funds: since the investor is informed of the exact portfolio composition. and the investor must have time and the ability to analyse it. since other market participants can easily make use of this information to trade against a hedge fund's strategy. An EDHEC Risk and Asset Management Research Centre Publication . the scope for unexpected or even fraudulent behaviour by the hedge fund manager is very limited. instead of individual securities. for many investors the convenient and rather easy to understand return-based reporting might be more appropriate. investors usually face an additional liquidity risk due to the lock-up periods.2. is counterproductive to good hedge fund performance. risk analysis using portfolio holdings requires not only current and past portfolio holdings. Since illiquid positions are very common in hedge funds. In addition to these risks. as mentioned in section 2. Hence. however. Finally.. If not done accurately. the differences between market and realised prices. However. Since illiquid assets tend to exhibit relatively constant prices. Full portfolio disclosure.2. Asset liquidity risk is a fund's risk of being unable to sell positions in the portfolio.Note that both kinds of liquidity risk refer to risks in hedge funds. Hedge funds can also provide estimated impact costs.November 2008 2.

. A good overview of leverage indicators is found in Rahl (2003). It is important to note that leverage is not bad in itself. They observe that the coefficients of the factors in style analysis should add up to one if no leverage is used. Breuer (2000) suggests incorporating off-balance sheet leverage exposure in the ratios (such as that represented by futures) by calculating their balance sheet equivalent. volatility-to-equity. (2005) propose another risk-based leverage measure using hedge fund style analysis. hedge funds can simulate funding liquidity stress tests to evaluate the impact of adverse market conditions on the cash situation of the fund. or stress loss-to-equity.November 2008 2. By relating future payments and redemptions to each other. Neglecting this exposure can be misleading. Although leverage is not a source of risk on its own. For example. such as gross assets-to-equity. Accountingbased leverage indicators are usually 32 An EDHEC Risk and Asset Management Research Centre Publication simple ratios of information found in a hedge fund's financial statement.Hedge Fund Reporting Survey . both on and off balance sheet. hedge funds can make use of financial leverage by borrowing large amounts of capital. stress tests can help to analyse the impact of critical market situations on a portfolio's liquidity. For example. off-balance sheet leverage risk is automatically included via the risk component in the numerator. it usually amplifies all other risks. Asset-liability match analysis attempts to examine the timing of portfolio transactions. Finally. similar to extreme performance risks. 2. Funding liability risk indicators try to capture the provision of cash to meet obligations.5 Leverage risk indicators Unlike mutual funds. such as cash-to-equity or VaR-to-cash ratios. Background investments. again. Risk-based measures are another possible means of capturing off-balance sheet leverage. The aim of these measures is to capture the leverage of a fund by relating its risk exposure to a balance sheet component. Some of the prominent ratios are VaR-to-equity. since any deviation from one is a clear sign of using leverage. These measures. Liquidity ratios.3. are a simple class of funding liquidity risk measures. The problem with these ratios is that they do not capture off-balance sheet leverage. futures can imply high leverage but may not appear in the financial statements. Leverage risk indicators can be classified in two main groups: accounting and risk based leverage measures. usually net asset value of equity. Similarly to asset liquidity. a sum of beta coefficients of two indicates a portfolio risk exposure twice as large as the investors' capital. and hence leverage of 100%. debt-to-equity. But there is no universal leverage risk indicator. this analysis helps to detect possible mismatches and thus liquidity constraints well in advance. Especially great is the impact of leverage on liquidity risk. or their inverses allow an initial assessment of a fund's leverage. since the usefulness of the indicator depends very much on the hedge fund strategy. Here. For this reason. This observation led the authors to the conclusion that the sum of the coefficients is a very useful leverage indicator. as it is a convenient means of shifting a portfolio towards the desired risk-return profile. McGuire et al.

the calculation of its net asset value is not simple. or trading activities outside of the fund's mandate. and all yield different results. the hedge fund should provide as much information as possible on the hedge fund management itself. any fund should disclose the existence of such arrangements. Valuation framework The most important part of operational risk disclosure is. Another source of operational risk is the involvement of third parties. an irregular disclosure of important information on the occasion of significant market or strategy changes. Hence. it is not always obvious which valuation technique—and thus which valuation—is most appropriate. That this risk is the cause of so many failures underscores the need for disclosure. fraud. and the planned use of leverage. For liquid assets. The hedge fund team should consequently disclose the main counterparties of the hedge fund and provide a short analysis of the risks involved in outsourcing activities to partners. Conflicts of interest can also occur between hedge fund investors. such internal conflicts can arise when managers run different hedge funds.1. Background 2. but detailed operational risk disclosure can reduce its impact significantly.).1.6 Operational risk disclosure Although often neglected as an independent source of risk. Since hedge funds invest in many different and complex financial products.3. For this reason. bid. It also includes a detailed description of the organisation of the fund: the legal framework. We summarise below the main valuation principles used by hedge funds. Next. market prices general the best source of an value. some of which are not regularly traded. We describe below the basic ingredients of operational risk disclosure.Hedge Fund Reporting Survey .g. by far. and they calculated as an average over a are in asset's either can be certain 33 An EDHEC Risk and Asset Management Research Centre Publication . half of all hedge fund failures are caused by operational risk problems. Moreover. operational risk is perhaps the greatest risk for hedge fund investors. a clear statement of a fund's valuation principles is indispensable. As Giraud (2005) shows. information on proxy voting. each hedge fund should issue a private placement memorandum (PPM) that provides an overview of the hedge fund's strategy. the valuation framework. prices can be ask.e. including its investment style. Since risk related to a fund's valuation framework accounts for the lion's share of operational risk disclosure. redemption rights. such as misrepresentation of a fund's net asset value. Often there are many ways to calculate the current value of a specific asset. It is clear that no investor can expect to be fully insured against fraud by hedge fund management. hedge funds should arrange for special event reporting. In addition to the problems relating to fee incentives (see section 2. so they could be inclined to manage the fund's allocation to optimise their joint fee income. or fee structure of the fund should be stated clearly. However. the vitae of the managers and the possible conflicts of interests of the management team. i. or mid-prices.. it is presented in a separate paragraph..November 2008 2. Finally. e. First. such as those induced by side letters and parallelmanaged accounts for some specific investors. the asset classes it uses and its geographic exposure.

arbitrage pricing models are useful. One possibility is to use pricing models: derivatives are best priced with stochastic pricing models. Obtaining a value for illiquid assets is much more difficult.Hedge Fund Reporting Survey . Loans or private equity investments might be valued with the help of discounted cash flow models. 34 An EDHEC Risk and Asset Management Research Centre Publication . who is in charge of the valuation. hedge fund managers might opt to do the valuation themselves. It is sometimes possible to assign the valuation of difficult and complex assets to third parties. If related financial instruments are traded in the market. it is possible to ensure compliance with the valuation framework by strictly separating the duties of the manager and administrator. counterpart quotes or estimates are another source of an asset's value. but have valuation policy validated by an external auditor.November 2008 2. An initial mechanism is to assign the determination of the fund's net asset value to a third party valuation service provider or administrator. Finally. Background time period. If the valuation is done in-house. Finally. It is also important to have clear control mechanisms that ensure that the valuation principles are respected at all times.

3. Methodology and Data An EDHEC Risk and Asset Management Research Centre Publication 35 .

finally. Exhibit 1: Country of survey participants 10. is made up of fund of hedge fund managers.4% Fund of hedge fund management Hedge fund management Investor . Finally.7% 17. 3.5% 17. The next set of questions turns to the central issue of this survey: appropriate performance measures and performance risk indicators. Funds of hedge funds are investors and fund managers at the same time. The third group of survey participants.1 Methodology The EDHEC Hedge Fund Reporting Survey was taken with an online questionnaire and electronic mail to European professionals in the hedge fund industry. The exact breakdown is shown in exhibit 1. Next. Since hedge fund investors are a heterogeneous group. First.2 Data The survey was taken in the summer of 2008. this survey invited hedge fund investors to respond. The questionnaire consisted of three sections with roughly twenty-five multiple choice questions each.7% 4. and France. In a first series of questions.3% Exhibit 2: Profession of survey participants 38. Methodology and Data 3.8% United Kingdom Switzerland Italy non EU France Germany other EU 9. Switzerland. In the last set of questions. The first response was received on July 4. 2008. survey participants were given the possibility to add further comments on the general issue of hedge fund reporting. and their views can thus provide comprehensive insights into hedge fund reporting. this questionnaire was addressed to hedge fund managers. the last on October 1. and in counterpoint. Nearly 90% of the 214 respondents to the survey are based in Europe. the questionnaire asks participants for their view on such issues of hedge fund reporting. since they ultimately decide how their funds will report.3% 31.Hedge Fund Reporting Survey . many of them in the UK. To capture the conflicting views and opinions on hedge fund reporting. since it is acive on both sides of the hedge fund industry. this survey targets three groups of professionals.8% 4. the survey participants are asked for their general view on the importance of and their satisfaction with current hedge fund reporting.3% 35. This professional group is perhaps the most interesting. as liquidity risk and leverage risk reporting. it was our aim to target a broad mix of institutional and private investors. or on the disclosure of 36 An EDHEC Risk and Asset Management Research Centre Publication operational risk in hedge fund reports.November 2008 3. and quite evidently.3% 30. 2008.

fund managers. However.e. CFO. The remainder are either private bankers or private investors. with An EDHEC Risk and Asset Management Research Centre Publication 37 . Methodology and Data Next. exhibit 4 shows the assets under management of the companies for which the survey respondents work.2% CEO/Managing Director Head of Risk Management Head of Asset Allocation Associate/Analyst CIO/CFO Head of Reporting Services Portfolio/Fund Manager Marketing Position 6. Some two-thirds of the investors are institutional investors (pension funds.8% 4. fund of hedge fund managers.Hedge Fund Reporting Survey .7% 18. are almost equally represented. our survey mainly reflects the views of medium-sized companies. This regional diversity and the fair balance of the hedge fund professionals make the survey largely representative of the European hedge fund industry.November 2008 3. or head of risk management (see exhibit 3). Exhibit 3: Function of survey participants 10. and more than half have such positions as CIO. with assets under management of between 100mn and 10bn EUR. As was to be expected. Exhibit 4: Assets under management (EUR) 19.7% 20. as can be seen in exhibit 2.7% 9. i. insurance companies).. there are a few very large firms in the hedge fund industry that have more than 100bn EUR in assets under management.2% 10. all three target groups of this survey. and investors.5% Finally. We also capture the opinions of small firms. The respondents occupy high-ranking positions: 20% are CEOs.1% 20% having assets under management of less 100mn EUR.

November 2008 3.Hedge Fund Reporting Survey . Methodology and Data 38 An EDHEC Risk and Asset Management Research Centre Publication .

The View of the European Hedge Fund Industry on Current Disclosure Practices A n E D H E C R i s k a n d A s s e t M a n a g e m e n t R e s e a rc h C e n tre Pub l i ca ti on 39 .4.

November 2008 4. The View of the European Hedge Fund Industry on Current Disclosure Practices In this section. We will return to this issue in subsection 4. we follow the structure of the previous background chapter so that for each topic interested readers can easily find the corresponding detailed explanation in section 2. In principle. Exhibit 6: Objectives of hedge fund reporting 40 An EDHEC Risk and Asset Management Research Centre Publication .2. The result is clear: over 90% of all participants indicate that the reporting quality of a hedge fund is an important signal for the fund's overall quality (see exhibit 5).1. we look into the overall importance of hedge fund reporting. Risk information for the investors' total asset allocation (47%) and performance attribution (45%) are also viewed as important objectives of hedge fund reporting.Note that in the following—if not otherwise stated—fund of hedge fund managers are sometimes considered investors. section 4.1. other times fund managers.1 Hedge Fund Reporting: the Big Picture 4.1. and the industry's most important information sources for good hedge fund disclosure.Hedge Fund Reporting Survey . Finally.2 Objectives of hedge fund reporting We then examine what industry practitioners view as the main objectives of hedge fund reporting. First. leverage. Most practitioners (61%) think that the main objective of hedge fund reporting is to assess the risk/ return profile of the hedge fund under consideration. we present the survey results. Exhibit 6 shows the results.1 Hedge fund reporting as quality signal First.1. we turn to the the key indicators of hedge fund performance and risk. we take a general look at the industry's perception of hedge fund reporting. Exhibit 5: Is hedge fund reporting an important signal for a hedge fund's overall quality? 4.5. 4. such as liquidity. and operational risk.3 examines specific risks hedge funds are generally exposed to.13 13 . Put differently. many investors are likely to hold back investment. In section 4. investment decisions can hinge on reporting quality: if it is not sufficient. objectives. its importance. depending on the question. in section 4. These findings stand in contrast to other cited objectives of hedge fund reporting: only 17% perceive reporting as a means of advertising the funds' quality and 12% see hedge fund disclosure as a way for investors to ensure that regulatory scrutiny will turn up nothing untoward.

investors tend to require more information than hedge fund managers deem important. high frequency is not required to achieve the objectives of hedge fund reporting as reported by survey respondents Surprisingly. and timely. In contrast.3 Components of good hedge fund reporting Against the backdrop of the survey respondents' views of the main objectives of hedge fund reporting. hedge fund managers themselves regard this aspect of reporting as rather unimportant (15%). Agreement is highest on the necessity of the consistency and clarity of hedge fund reporting. hedge fund reporting should be consistent. by contrast.November 2008 4.1. information about operational risk is considered largely unimportant. we analyse what they believe to be the keys to achieving these objectives. Exhibit 7: What is important for a good hedge fund report? Exhibit 8. Most of all. 4. and the portfolio composition of hedge funds than fund managers consider necessary. Exhibit 9 shows the satisfaction with the facets of hedge fund reporting as identified by both fund of hedge fund managers and 41 An EDHEC Risk and Asset Management Research Centre Publication . For example.4 Satisfaction with current hedge fund reporting After having created the frame for the industry participants' view of important elements of hedge fund reporting. we now turn to the investors' satisfaction with current reporting practices. whereas fund of hedge fund managers consider reporting a major means of controlling managers' behaviour (46%). This observation shows that operational risk is considered unimportant only by fund managers.Hedge Fund Reporting Survey . these fund managers consider reporting a useful fund selection device (51%) and a means of advertising their products (26%). But investors would like to see much more disclosure on liquidity risk. In general. It shows that hedge fund managers and investors have diverging views on what constitutes solid reporting. they diverge remarkably in some aspects. The same holds true for the qualitative outlook on the hedge fund's strategy. find that advertising is a negligible component of hedge fund disclosure (7%). Investors. In contrast. The View of the European Hedge Fund Industry on Current Disclosure Practices Although those in the industry largely agree on the objectives of hedge fund reporting. Exhibit 8 shows the important components of hedge fund disclosure by professional group.1. operational risk. clear. Fund of hedge fund managers often take the middle way. The answers are shown in exhibit 7. What is important for a good hedge fund report? Anwers by professional group 4. Information on the fund's absolute risk is considered most important.

The View of the European Hedge Fund Industry on Current Disclosure Practices investors.November 2008 4. Exhibit 11: Information sources for good hedge fund reporting Many of the hedge fund managers and investors have internal disclosure guidelines as well. we examine the information sources that are most influential for the industry's opinion of optimal hedge fund disclosure. Investors are satisfied with the consistency. investors express concerns about the quality of the disclosure on liquidity and operational risks. and frequency of their hedge funds' disclosure. although end investors tend to be less content.5 Information sources for hedge fund reporting standards Finally. The scatter plot thus makes it possible to identify aspects of hedge fund reporting that are judged very important. between 70 and 80% of investors have internal disclosure standards that must be met before they 42 An EDHEC Risk and Asset Management Research Centre Publication . followed by operational risk reporting. Frequency of reporting and information on past returns have the highest such ratio. 4. but for which standards are not yet met (upper left part of the plot). clarity.Hedge Fund Reporting Survey . In fact. Academics.1. both groups of hedge fund investors have a similar view on hedge fund disclosure quality. disclosure on liquidity risks exhibits the worst quality-to-importance ratio. Exhibit 11 shows that so-called "best practices" and industry guidelines by government working groups or industry associations have the greatest impact on the industry (63% of the respondents). consultancies and public opinion have little impact on the industry's view of hedge fund disclosure. In general. Information on past returns also appears satisfactory. However. Exhibit 9: Satisfaction with hedge fund reporting Answers by professional group Exhibit 10: Hedge fund reporting—wishes and reality Answers by fund of hedge fund managers and investors Exhibit 10 takes another look at investors' satisfaction by opposing perceived importance with the perceived quality of the aspects of hedge fund reporting. Next important is the opinion and practices of industry peers. Not surprisingly.

and correlation (or beta) tests.2.November 2008 4. The results are displayed in exhibit 14. as can be seen on the right side of exhibit 12. Maximum past drawdown. all indicators can be classified into one of four groups: return analysis. This again underscores the importance of hedge fund reporting. Other indicators 43 An EDHEC Risk and Asset Management Research Centre Publication . is regarded as the most important indicator obtained from past returns. there is some agreement that correlation or beta analysis is a rather unimportant part of overall hedge fund performance disclosure.2 Key Indicators: Performance Indicators and Risk Measures In this subsection.1 Return analysis Our first look is at the descriptive statistics and statistical tests of hedge fund returns that are considered essential for the return analysis. The View of the European Hedge Fund Industry on Current Disclosure Practices actually invest in a hedge fund. The results. we ask all industry practitioners to rank these four elements of performance and risk analysis by order of importance. whereas investors and fund of hedge fund managers consider them the least important. extreme risk measures. reveal major differences in the relative importance of these key indicators. risk-adjusted 4. The survey shows that both investors and hedge fund managers have a clear preference for simple but informative return indicators. we take a closer look at the key performance indicators and risk measures used in hedge fund reporting.Hedge Fund Reporting Survey . First. an easy indicator of a fund's downside risk. as shown in exhibit 13. Exhibit 13: What risk measures are important for a good hedge fund report? Answers by professional group 4. Hedge fund managers believe in the importance of risk-adjusted performance measures. However. These two professional groups report that return analysis and extreme risk measures are the most important means of evaluating a hedge fund's performance. Over 60% of the the hedge funds have clear guidelines for information they disclose to their investors. Exhibit 12: Existence of internal disclosure rules Answers by professional group performance analysis. Essentially.

one can stress-test only the impact of problems that are potentially known in advance. practitioners also view information on the fund's volatility and return persistence as crucial. and they can differ substantially from one fund to another. Put differently. they are opaque: the assumptions behind the stress tests are not always obvious. we turn to the industry's opinion of extreme risk indicators.2 Extreme risk indicators Next. 2001). are seen as superior to simple parametric implementations is very encouraging. That advanced Value-at-Risk models. Besides downside risk. Given the relative importance of Valueat-Risk measures.Answers by professional group Second. Exhibit 14: Important elements of return analysis of hedge funds . First. we also attempt to determine whether investors and fund of hedge fund managers are aware of the models used to calculate Value-at-Risk as it appears in hedge fund reporting. or tests of their normality appear not to be of particular interest to the hedge fund community. closely related to VaR. Since the information value of VaR depends very much on the chosen model.November 2008 4. not publishing their assumptions is unacceptable.Hedge Fund Reporting Survey . This nearly unanimous embrace of stress tests is surprising. This overwhelming approval of stress tests is found industry-wide. they are highly subjective (Jorion. Exhibit 15: Important extreme risk measures for good hedge fund reporting 4. such as those based on non-normal Monte Carlo simulations. with only 20% unaware of how VaR is calculated. But it is problems that cannot be foreseen that are the real test of a fund's risk management. 44 Value-at-Risk is also very important to the hedge fund industry. investors and hedge fund managers agree on their importance. as they come with two major drawbacks. is also very popular in the industry. Fund of hedge fund managers seem to be somewhat better informed. The View of the European Hedge Fund Industry on Current Disclosure Practices about downside risk deemed important are the fund's returns during extremely negative equity markets and the lower partial moments of hedge fund returns. It turns out that more than 40% of all final hedge fund investors indicate that they do not know how the Value-at-Risk information is calculated (exhibit 16). An EDHEC Risk and Asset Management Research Centre Publication . such as the skewness and kurtosis of hedge fund returns. More rigorous and sophisticated statistical measures and tests. The results are striking: more than two-thirds of respondents believe that stress tests are the most important means of assessing a hedge fund's extreme risk exposure (see exhibit 15).2. Conditional VaR.

The results are shown in exhibit 18. are interchangeable.Answers by professional group 4. the Omega ratio. Although this popular ratio has the advantage of being easy to calculate.November 2008 4. The exhibit also shows that investors are much more convinced of the usefulness of this approach than are managers.2. as perceived by the industry.. The exhibit shows that more than 67% of all respondents—regardless of their profession—consider the Sharpe ratio the best means of measuring a fund's risk-adjusted return. which is more suitable for hedge funds. Exhibit 18: Importance of factor models Anwers by professional group An EDHEC Risk and Asset Management Research Centre Publication 45 . Other important measures include the information ratio. First. the explanation of hedge fund returns by their systematic risk exposure with the help of factor models. comes next for assessing hedge fund returns (55%). such as the Calmar and Sterling ratios. many of the indicators. it is not surprising that many are not widely used.2.Hedge Fund Reporting Survey . Exhibit 17: Importance of risk-adjusted performance measures for good hedge fund reporting 4.4 Beta analysis The fourth component of a hedge fund's risk and performance analysis is correlation or beta analysis. it is not appropriate for evaluating hedge funds. The View of the European Hedge Fund Industry on Current Disclosure Practices Exhibit 16: Do your hedge funds indicate how they calculatedVaR? . with non-linear models slightly preferred. The graph emphasises that beta analysis using factor models is considered important. since it is based on the (mistaken) assumption that returns are normally distributed. especially hedge fund managers. Given the multitude of indicators. survey participants are asked for their opinion on both linear and non-linear factor models. i. It it therefore encouraging that the Sortino ratio. and the modified Sharpe ratio.e.3 Risk-adjusted returns Exhibit 17 shows the most important riskadjusted return indicators. Moreover. This finding underscores that industry participants are well aware of the shortcomings of simple linear approaches to modelling hedge fund returns.

as acknowledged by a substantial fraction of the managers responding to our survey.Hedge Fund Reporting Survey . So. so the information obtained is insufficient.5 Alpha analysis Alpha is simply the intercept of the factor models used to calculate the beta exposure in the previous section—and thus theoretically redundant. we turn to hedge fund managers and look into whether they actually disclose their fund's factor exposure to investors. However. As argued above.November 2008 4. The View of the European Hedge Fund Industry on Current Disclosure Practices Against this backdrop. are at odds with their investors' perceptions. non-linear models (see exhibit 21).2% 77. the reporting of beta exposure is likely to remain a controversial issue for the hedge fund industry. They may be afraid of publishing their strategic or tactical exposure. or that they restrict information disclosure to keep reports concise (see exhibit 20). such models are far from appropriate for modelling hedge fund returns.8% Exhibit 20: Why don't you disclose these additional measures? Answers by professional group Finally. Exhibit 21: Which factor models do you use? Answers of all respondents that publish factor exposure Linear factor models Non-linear factor models 4. we take a look at those managers who report beta analysis to investors. All the same. however. hedge fund managers are either unaware of their clients' true needs for information or unwilling to state their reasons for failing to disclose their fund's factor exposure. We also find that many hedge funds believe that investors are uninterested in the beta exposure. Although these investors are in a better position than their uninformed peers. For investors.2. These practices. as seen in exhibit 18. Exhibit 19: Do you publish the factor exposure of your hedge fund? Answers by professional group 22. the answers are disappointing. many receive information on factor exposure using only simple. Only some 15% of all hedge funds disclose this important information (exhibit 19)—an unacceptably low percentage. 46 An EDHEC Risk and Asset Management Research Centre Publication .

Only about half of the respondents argue that factor models—either linear or non-linear—should be used to estimate alpha. We then ask which methods should be used to calculate a fund's alpha.e.6 Disclosure of performance measures To conclude this section on risk and performances indicators. or it can be considered an indicator of abnormal returns. It can be regarded as a measure to compare the performance of a fund to a benchmark. many respondents also report that the return difference to a hedge fund index would be appropriate for estimating alpha. peer group comparisons and return differences to hedge fund indices are inappropriate.2. Exhibit 22 shows the industry's opinion of the use of alpha in hedge fund reporting. An EDHEC Risk and Asset Management Research Centre Publication 47 . a large majority (over 60%) of hedge fund managers use more performance indicators than they publish (see exhibit 24). As it happens. In either case.. however. since they do not reflect all the risks of investing in hedge funds. i.November 2008 4. The result is clear. Exhibit 22: Is alpha analysis important? Answers by professional group Exhibit 23: Which methods should be used to calculate alpha? Answers by professional group 4. Regardless of the professional group. In a similar vein. alpha analysis is considered very important—and appears to be more important than the factor analysis itself. Alpha analysis can be used in two different ways. The most frequently mentioned technique for calculating alpha is the hedge fund's return difference compared to a peer group (see exhibit 23). we ask whether hedge fund and fund of hedge fund managers calculate any risk and performance measures that they use internally without disclosing to investors.Hedge Fund Reporting Survey . The View of the European Hedge Fund Industry on Current Disclosure Practices given its widespread interpretation as risk-adjusted or abnormal return. it is often included in hedge fund reports and treated separately. returns that cannot be attributed to a fund's risk exposure. The answers are striking.

and are thus unsuitable for hedge funds (see sections 2.2. more than 60% of those responding to the survey do not know how to measure non-normality. Exhibit 25: Why don't you disclose these additional measures? Answers by professional group Why not let the investors decide which information is important? Perhaps to keep reporting concise. the respondents' knowledge of this issue seems to come to an end at this point.November 2008 4. we examine practitioners' views of risks and issues of particular importance to the hedge fund industry. The remaining 10% argue that no test is needed.2. Non-normality can have considerable consequences on the risk and performance evaluation of hedge funds. more than 20% of the hedge fund managers taking our survey do not answer this question.3. The View of the European Hedge Fund Industry on Current Disclosure Practices Exhibit 24: Do you use additional performance measures for internal use only? Answers by professional group 4. since standard measures are based on the assumption of normality.1. Exhibit 26 indicates that most industry professionals. Only 20% of all fund of fund managers and 40% of all hedge fund managers state that reporting additional figures would mean too much disclosure of their investment strategy.2 and 2. it is widely accepted that hedge fund returns are not normally distributed.3 Specific Hedge Fund Risks Reconsidered In the final set of questions. This raises the question of why fund managers hold back potentially important information that they consider relevant for themselves.3. agree that nonnormality is an important issue for the hedge fund industry.Hedge Fund Reporting Survey . Only about 30% of the respondents have a view on appropriate tests. given the abundant 48 An EDHEC Risk and Asset Management Research Centre Publication . perhaps a valid viewpoint. As exhibit 25 shows. As exhibit 27 shows. Answers by professional group Interestingly.3 for more discussion). Exhibit 26: Non-normality is an important issue for measuring hedge fund performance. However. as about 50% of the respondents argue. 4.1 Non-normality of hedge fund returns As presented in section 2. largely regardless of their exact professional role. the main motivation for their failure to disclose these additional performance and risk measures is that they believe investors are uninterested in these indicators.

When asked what they consider the main reasons for the smooth returns of We then turn to possible solutions to the problem of smoothed returns. Most interesting is the observation that this percentage is equally high industry-wide. To conclude. Again.2 Smoothing of hedge fund returns Exhibit 28: Return smoothing is a significant issue for measuring hedge fund performance The smoothing of hedge fund returns is another delicate issue investors commonly face. there is a significant gap between theory and practice: evidence shows that the industry is well aware of non-normality.3. Exhibit 30 shows that smoothing-robust measures are rarely used. the socalled smoothing-robust performance measures.. hedge fund managers are no less likely than their investors to say that they themselves—or their less scrupulous colleges—misstate the prices of some assets to achieve smoother (i.2. Less than 5% of 49 An EDHEC Risk and Asset Management Research Centre Publication . Exhibit 27: What test should be used to detect non-normality of hedge fund returns hedge funds. However many industry participants appear not to be convinced by the usefulness of these measures.. less volatile) returns. as discussed in section 2. Another 23% argue that weighting of different asset prices available at the same time is a major reason for smooth returns. after all. Put differently. more than 70% fully or largely agree with the statement that return smoothing is a significant issue for measuring hedge fund performance risk. i. Surprisingly.November 2008 4. almost 30% are convinced that smooth returns are a clear sign that hedge fund managers deliberately modify the prices in the direction they want. The View of the European Hedge Fund Industry on Current Disclosure Practices empirical evidence for non-normality of hedge fund returns.e.3. Exhibit 29: Reasons for return smoothing 4. that they use the illiquid assets to manipulate their fund's returns. As exhibit 28 shows. Most respondents argue that these measures are very complicated (52%) or express concerns that even these sophisticated measures could be manipulated (55%). there are no significant differences from one industry profession to another.e. the Sharpe ratio is still preferred for measuring risk-adjusted returns (see exhibit 17).Hedge Fund Reporting Survey . most practitioners indicate the linear extrapolation of illiquid asset prices (exhibit 29). but does not always draw the right conclusions.

Hedge Fund Reporting Survey . By contrast.3. Exhibit 31: Advantages of holdings-based reporting Exhibit 32: Challenges of holdings-based reporting 14 .3. The View of the European Hedge Fund Industry on Current Disclosure Practices the fund managers state that they disclose performance based on these measures. and less than 20% of the investors receive such measures from their funds. whereas in fact they are not). That up to 30% of investors do not even know whether they receive such information is perhaps an indication that many survey respondents are unaware of the existence of robust measures. as argued in section 2. . 4.3. Other disadvantages mentioned are the time lag with which investors receive the information (41%) and the observation that holdings based reporting works only with very detailed information (34%).3 Holdings-based reporting We seize the opportunity of this survey to ask practitioners what they perceive to be the pros and cons of holdings-based reporting. a possible solution to at least some of the problems of hedge fund 50 An EDHEC Risk and Asset Management Research Centre Publication Respondents report that the main advantage of holdings-based reporting is that it affords the possibility to carry out a very detailed risk analysis (75%). Exhibit 30: Do you publish or receive return-smoothing robust performance measures? Answers by professional group reporting.14 This low proportion might reflect the industry's critical view of such indicators.November 2008 4. nearly half of respondents argue that holdings-based reporting requires a lot of know-how and means substantial data analysis (both 48%).The proportion of investors that receive robust performance information (20%) should be more or less equal to the percentage of funds that disclose such information (5%). The answers are broadly similar across all hedge fund professions. The divergence can be explained by either a mismatch of the samples (investor respondents are investing preponderantly in funds that are disclosing more information than those of our sample) or by badly informed investors (they consider the returns they got robust. The results are shown in exhibits 31 and 32. it has the advantage of letting an investor choose his own techniques to analyse a fund's riskiness (56%) and of transparency greater than that of return-based reporting (51%).

November 2008 4.3. and fund of fund managers would choose holdings-based reporting. we turn to risks that are of particular importance to hedge funds. whereas 50% do not. Investors have no clear preference. fund of hedge fund managers.Hedge Fund Reporting Survey . Exhibit 34: Do you offer holdings-based reporting to your clients? 4. First. Some 80% of all respondents state that liquidity risk is not sufficiently captured in hedge fund reporting (exhibit 36). half of the practitioners would prefer holdings-based reporting and the other half would opt for return-based reporting (see exhibit 33). we examine the industry's view of the relevance of the liquidity risks to their business (see exhibit 35). This finding is quite intuitive: since hedge fund managers might fear that too much valuable detail about their investment strategy would be revealed to the public. Finally. Yet this clear view contrasts sharply with the industry's satisfaction with the current coverage of liquidity risk in hedge fund disclosure. are much more positive about holdingsbased reporting. especially for hedge fund investors. Exhibit 34 shows that about onethird of hedge funds offer this service to their investors.4 Liquidity risk Next. they favour returnbased reporting. 47% of those who receive this information from their hedge fund managers report The answer is unequivocal: liquidity risk is considered a major source of risk for hedge funds. we investigate how commonly used holdings-based reporting actually is. An EDHEC Risk and Asset Management Research Centre Publication 51 . Exhibit 35: Is liquidity risk an important source of risk for hedge funds? Answers by professional group Again. In contrast. Yet there are significant differences between the professional groups. hedge fund managers prefer return-based reporting. which reporting style would you prefer? Answers by professional group that they are satisfied with it. The View of the European Hedge Fund Industry on Current Disclosure Practices If asked to express a preference for one of the two reporting styles. This corresponds to the investors' declaration that about 43% of them actually receive holdings-based information. since they might be more competent in dealing with this reporting style than end investors. more than 80% of whom classify this source of risk as "very important". who are probably the most sophisticated class of investors. Exhibit 33: If you had to choose between holdings and return based reporting. 22% report that they are not (not shown).

more than 67% consider this indicator one of the most important liquidity risk indicators).3. many industry participants believe that liquidity risk is hard to define (30%). Exhibit 39: Is leverage risk an important source of risk for hedge funds? Exhibit 38: Important liquidity risk indicators However. risks related to leverage appear to be better reflected in current hedge fund reports than are liquidity risks. Exhibit 37: What are the problems of liquidity risk reporting? Answers by professional group As far as liquidity risk measures are concerned. however. Information on the percentage of hard-tovalue assets of the portfolio is also perceived to be important. Exhibit 40 indicates that between 31 and 39% of industry participants consider that leverage risk is well captured by current hedge fund reports. that existing liquidity measures are not good enough (27%). 4.November 2008 4. practitioners believe that liquidity risk is simply neglected in current hedge fund disclosure practices (55%). most practitioners value information on average liquidation periods highly (as exhibit 38 shows. Even so. and is thus judged equally decisive as liquidity risk. 52 An EDHEC Risk and Asset Management Research Centre Publication . Most of all. there is no difference across the three professional groups. only 30% of hedge fund managers report similar dissatisfaction—again a sign that investors overestimate the quality of their reporting. or that they do not capture all the facets of liquidity risk (38%). Statistical tests such as the Ljung-Box test play only a minor role for the industry. So why is liquidity risk reporting so bad? As exhibit 37 shows. our survey participants also agree that leverage risk is also a major risk component for hedge fund investment strategies: more than 96% state that leverage risk is an important or a very important source of risk for hedge funds. The View of the European Hedge Fund Industry on Current Disclosure Practices Exhibit 36: Is liquidity risk well captured by current hedge fund reports? Answers by professional group Amazingly. even hedge fund managers admit the poor information disclosure on hedge fund liquidity risks.Hedge Fund Reporting Survey . 54% of all end investors are dissatisfied with leverage risk reporting.5 Leverage risk As exhibit 39 shows.

November 2008 4. These ratios are definitely much better indicators than the simple balance sheet ratios. such as contained in futures. we attempt to identify industry views of the most important elements of operational risk reporting. Information on internal risk management and internal controls are also seen as major aspects of operational risk reporting. we then ask those surveyed whether the information provided on operational risk is sufficient or meets their demands (as investors).Hedge Fund Reporting Survey .3. Very clearly. As with the analysis of other risks. Exhibit 41: Important leverage risk indicators. Answers by professional group risk reporting. these two key elements of hedge fund reporting require substantial improvement. that is. hedge funds rate their information disclosure more highly than do fund of hedge fund managers and investors. reveal that exactly those aspects that are considered most important are those that are considered most wanting. as argued in section 2. it is issues related to the pricing and the valuation of hedge funds (identified by more than 76%) that the industry views as the most crucial elements of operational Exhibit 43: Does hedge fund reporting provide investors with sufficient information on…? Answers by group An EDHEC Risk and Asset Management Research Centre Publication 53 . operational risk. shown in exhibit 43. Risk-based leverage measures. information on a fund's valuation framework and on the internal controls a fund puts in place. such as VaR-to-equity are also popular—and sensible indicators as well. As exhibit 42 shows. Since it is even more difficult to comprehend than risk related to a fund's liquidity. Exhibit 42: Important aspects of operational risk reporting 4. are considered the most important leverage risk indicators (exhibit 41).6 Operational risks Finally. as is to be expected.3. The View of the European Hedge Fund Industry on Current Disclosure Practices Exhibit 40: Is leverage risk well captured by current hedge fund reports? Answers by professional group Ratios that include off-balance sheet leverage. The answers. we examine the practitioners' perception of one of the most intangible risks for hedge funds. Moreover.5.

Although this procedure is objective and has intuitive appeal. About 62% of respondents believe that the disclosure of the proportion of markto-market vs. Estimates provided by the managers are considered the second best way to obtain a price for difficult-to-price assets. The View of the European Hedge Fund Industry on Current Disclosure Practices Given the perceived importance of information on pricing and valuation and its unsatisfactory disclosure. Finally. as shown in section 2. manager estimates should be a last resort. One crucial aspect of a hedge fund's valuation is the treatment of hard-to-value assets. Most survey respondents (80%) favour external valuation of the fund's net asset value by independent platforms or administrators to ensure a consistent pricing policy (see exhibit 45). it cannot be regarded as a means of ensuring a that a fund complies with its pricing framework. Hedge fund managers ought to know the assets they hold and related asset markets better than many other market participants.Hedge Fund Reporting Survey . we investigate these issues in more detail. it will translate into overly smooth total hedge fund returns. Thus. In exhibit 44 we show the industry's views on how to mitigate the risks of hard-to value instruments. however. only 25% believe that in-house validation with separation of duties or external auditing is an appropriate means of ensuring consistent valuation. but if the manager prices the instruments he holds on his own. are a doubleedged sword.3. this method might be used to 54 An EDHEC Risk and Asset Management Research Centre Publication . we seek the industry's opinion of the best valuation procedures or mechanisms to ensure coherent hedge fund valuation. Exhibit 44: What is your preferred approach to mitigating the risks of hard-to-value instruments? manipulate a fund's total value—clearly not in the interest of the investors. no pricing controls are possible. Manager estimates. Finally. Exhibit 45: Which of the following control mechanisms should be imposed to ensure coherent valuation? The overwhelming majority of respondents report that information provided by different brokers is the best means of pricing illiquid or hard-tovalue assets.November 2008 4. even if the overall fund valuation is verified by an independent third party.2. Hence. Although this ratio can obviously provide valuable information on the fund's sensitivity to partially subjective model pricing. mark-to-model pricing of the overall fund is a very useful means of ensuring consistent pricing. if there is no other means of obtaining reliable prices. suggesting that they might naturally be in a better position than anyone else to price these assets.

Conclusion An EDHEC Risk and Asset Management Research Centre Publication 55 .

other aspects of risk reporting could be easily improved without endangering a hedge fund's investment strategy. Investors are especially dissatisfied with the quality of information on liquidity and operational risk exposure. A large body of academic literature shows that many prevailing risk measures are not up to the task of reporting the true economic risks of investing in hedge funds. leverage and liquidity risk. The problem is not that there are no meaningful indicators. In this context. First. investors consider the overall disclosure insufficient. If they do so at all. or its factor exposure is especially wanting. since they already agree—in many cases—with their investors' view that hedge fund reporting is insufficient. is not suitable for reporting risk-adjusted hedge fund returns. such as those that call for consistent. great differences between hedge fund managers' perceptions of relevant information disclosure and their investor's needs suggest that the industry should rethink its overall disclosure practices. First. hedge funds and funds of funds should move to more appropriate risk and performance measures when disclosing their returns to investors. Finally. hedge fund managers should be ready to provide such information. many respondents still rely on this measure. the evidence on hedge fund reporting practices suggests that current guidelines and "best practices" of industry associations and government working groups are insufficient to enhance hedge fund transparency and thus investor confidence. Guidance on disclosure of a fund's risk-adjusted returns. Although these guidelines have a highly positive impact on the hedge fund industry. It is important . The results of this survey have a number of important implications for the hedge fund industry. However. and valuation frameworks. they are very vague and predominantly cover topics where there are already information disclosure standards. we find that the quality of hedge fund reporting is perceived to be an important indicator of a fund's overall quality and a crucial investment criterion. it sheds light on their perception of current hedge fund reporting practices. Although empirical studies present evidence that the Sharpe ratio. extreme risks. clear and timely reporting of past returns. for example. leverage risks.Hedge Fund Reporting Survey . To ensure greater hedge fund transparency. they rarely provide guidance on sound hedge fund disclosure. Although there might be sensible reasons not to disclose the portfolio composition 56 An EDHEC Risk and Asset Management Research Centre Publication of hedge funds in too much detail. In principle. existing guidelines should be extended to cover these risks as well.November 2008 Conclusion This study presents the results of a comprehensive survey of hedge fund professionals. Finally. these best practices fall short of encouraging hedge funds to provide information on very important aspects of hedge fund risks. but that they are not actually used. Hedge fund managers should take their investors' demands for more information seriously and improve disclosure on liquidity risks. this study also shows that inappropriate performance measures prevail in the hedge fund industry. it might be useful to make both hedge fund managers and investors more aware of the specific risks of their industry. we identify critical points of conflict in the alternative investment business. portfolio composition. Hence. Second. In analysing the industry's spectrum of opinions.

First. a better marketplace for hedge funds is likely to make a positive impact on market efficiency and financial innovation. An EDHEC Risk and Asset Management Research Centre Publication 57 . better reporting practices are likely to be beneficial to all in the industry. better informed investors will contribute to greater discipline on the part of hedge fund providers. All the same. Finally.November 2008 Conclusion to note that this statement should not be misinterpreted as a call for greater regulation of the hedge fund industry. Second. Improving the quality of hedge fund reporting lies at the heart of creating a more transparent industry environment. Better hedge fund transparency is likely to have many advantages.Hedge Fund Reporting Survey . it will lead to increased investor participation and less capital flight during financial crises.

Hedge Fund Reporting Survey .November 2008 58 An EDHEC Risk and Asset Management Research Centre Publication .

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Chichester. Shadwick (2002). John Wiley & Sons. 399-402. Best practices of the hedge fund industry. An EDHEC Risk and Asset Management Research Centre Publication 63 . working paper.November 2008 References • Keating. • Managed Funds Association (2007). 'On the Kolmogorov-Smirnov test for normality with mean and variance unknown'. 13-37. MSCI. • Liang. • Lilliefors. 'A universal performance measure'. (1996). John (1965). Eli Remolona and Kostas Tsatsaronis (2005). • Le Sourd. Nice. 297-303. • Kestner. Financial Analysts Journal 58(4). EDHEC publication. Sound practices for hedge fund managers. Journal of Portfolio Management 29(3). H. 'Risk management for hedge funds: Introduction and overview'. Biometrica 65(2). • Laporte. 'The statistics of Sharpe ratios'. Risk Management: A Modern Perspective. Box (1978). Technical report. Journal of Performance Measurement 6(3). 59-84. N. 'Getting a handle on true performance'. E. • Lintner. (1967). 44-46. chapter 8: The Hedge Fund Paradigm. 'Time-varying exposures and leverage in hedge funds'. A. 'The accurary of hedge fund returns'. 1-17. Franco and Leah Modigliani (1997). Hedge funds . Patrick. (2003). 'Assessing market risk for hedge funds and hedge fund portfolios'. 38-52. Journal of the American Statistical Association 62. European Parliament. Hedge funds. 59-72. 'The valuation of risk asset and the selection of risky investments in stock portfolios and capital budgets'. Bank for International Settlement Quarterly Review (March). • Modigliani.Hedge Fund Reporting Survey . Report of the Asset Managers' Committee. • — (2004). N. 45-54. and W. C. • — (2002). Narayan (2007). • McGuire. 16-33. • Naik. Journal of Risk Finance 2(4). • Posthuma. UK. • Ljung. Lars N. Review of Economics and Statistics 47. G. Journal of Portfolio Management 23. Financial Analysts Journal 57(6). Performance measurement for traditional investment. transparency and conflict of interest. Academic Press. and Pieter Jelle van der Sluis (2005). Bing (2003). P. François Serge (2001). Best practices of the hedge fund industry. • President's Working Group on Financial Markets (2008a). • Lhabitant. (2001). Futures 25(1). M. Report of the Investors' Committee. and G. • — (2008b). 'Risk-adjusted performance'. 'On a measure of lack of fit in time series models'. Modelling liquidity risk in a VaR model. Véronique (2007). • Lo.quantitative insights.

Dynamic beta. 40. (1991).A. 'Calmar ratio: A smoother tool'. • Stutzer. and Lee N. Frank. Laurens and Pieter Van Der Sluis (2006). M (2000). 'The arithmetic of active management'. 529-552. 'A portfolio performance index'. London. Journal of Business 39(1). • Sharpe. 'Performance measurement in a downside risk framework'. Journal of Portfolio Management 19. 'Mutual fund performance'. 'Capital asset prices: A theory of market equilibrium under conditions of risk'. 425-442. • Swinkels. —alternative risk-adjusted performance measures for alternative investments'. Xiaoqing Eleanor. • Zhang. and momentum. Journal of Portfolio Management 21. • Sortino. 22-31.November 2008 References • Rahl. Journal of Investment Management 2(4). Journal of Finance 19. (1964). Financial Analysts Journal 47(1). Futures 20(1). • — (1988). Hedge Fund Risk Transparency. Journal of Investing 3(3). L. 'The Sharpe ratio'. 64 An EDHEC Risk and Asset Management Research Centre Publication . William F. A. Risk Books. Leslie (2003). 'A. 'Asset allocation: management style and performance measurement'. • — (1991). J. Milind (2004). time-varying risk premium. • — (1992). 49-58. 63-75. Hong (2004). • — (1994). 52-61. 119-138. European Journal of Finance 12(6-7). 7-9. • — (1966). 'Return-based style analysis with timevarying exposures'. Harvard Business Review 43(1). 04-26. 'Do hedge fund managers display skill?'. • Treynor. 59-69. 7-19.R.P. Yale ICF working paper No. 34-65. Journal of Alternative Investments 6(4). 'How to rate management of investment funds'.Hedge Fund Reporting Survey . • Sharma. • Xu. 'Determining a fund's effective asset mix'. (1965). UK. Terry W. Price (1994). 59-65. Jot Yau and Hung-Gay Fung (2004). Investment Management Review pp.I. • Young. Financial Analysts Journal 56(3).

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constitutes a new opportunity in both conceptual and operational terms. the Centre has implemented six research programmes: Asset Allocation and Alternative Diversification Sponsored by SG Asset Management and Newedge 45. the prevailing stock market situation in recent years has shown the limitations of active management based solely on stock picking as a source of performance. This issue corresponds to a genuine expectation from the market. measuring the performance of funds while taking the tactical allocation dimension of the alpha into account. EDHEC has implemented a dual validation system for the work of the EDHEC Risk and Asset Management 66 An EDHEC Risk and Asset Management Research Centre Publication This research programme has given rise to extensive research on the subject of indices and benchmarks in both the hedge fund universe and more traditional investment . From that perspective. The choice of asset allocation The EDHEC Risk and Asset Management Research Centre structures all of its research work around asset allocation. Equis (Europe-Global) and Association of MBAs (UK-Global). Kaplan (2000) On the other. All research work must be part of a research programme. taking extreme risks into account in the allocation. To date. The EDHEC Risk and Asset Management Research Centre carries out numerous research programmes in the areas of asset allocation and risk management in both the traditional and alternative investment universes. The research carried out focuses on the benefits.Hedge Fund Reporting Survey .November 2008 About the EDHEC Risk and Asset Management Research Centre EDHEC is one of the top five business schools in France. private equity). EDHEC Business School has decided to draw on its extensive knowledge of the professional environment and has therefore focused its research on themes that satisfy the needs of professionals.5% Fees 11% Stock Picking 40% Strategic Asset Allocation Research Centre. NYSE Euronext. the relevance and goals of which have been validated from both an academic and a business viewpoint by the Centre's advisory board. risks and integration methods of the alternative class in asset allocation. The results of the research carried out by EDHEC thereby allow portfolio alpha to be measured not only for stock picking but also for style timing. the appearance of new asset classes (hedge funds. which integrate the alternative class. Lyxor Asset Management. which guarantees the scientific quality and the operational usefulness of the programmes. and UBS Global Asset Management An applied research approach In an attempt to ensure that the research it carries out is truly applicable. whether they involve proposing new methods of strategic allocation. The management of the research programmes respects a rigorous validation process.5 Tactical Asset Allocation Source: EDHEC (2002) and Ibbotson. BNP Paribas Investment Partners. with risk profiles that are very different from those of the traditional investment universe. EDHEC pursues an active research policy in the field of finance. Percentage of variation between funds 3. or studying the usefulness of derivatives in constructing the portfolio. This board is made up of both internationally recognised researchers and the Centre's business partners. On the one hand. Performance and Style Analysis Part of a business partnership with EuroPerformance The scientific goal of the research is to adapt the portfolio performance and style analysis models and methods to tactical allocation. EDHEC is making a significant contribution to the research conducted in the area of multi-style/multiclass portfolio construction. EDHEC is also one of the few business schools in Europe to have received the triple international accreditation: AACSB (US-Global). Indices and Benchmarking Sponsored by Af2i. Its reputation is built on the high quality of its faculty (110 professors and researchers from France and abroad) and the privileged relationship with professionals that the school has been developing since its establishment in 1906. Barclays Global Investors. This strategic choice is applied to all of the Centre's research programmes.

These indices are intended to be a response to the critiques relating to the lack of representativeness of the style indices that are available on the market. Particular attention is given to the institutional context of ALM and notably the integration of the impact of the IFRS standards and the Solvency II directive project. In 2003. the issue of operational risk. and the impact of market fragmentation resulting from MiFID on the quality of execution in European listed securities markets. Research also focuses on risk-adjusted performance measurement of execution strategies. constraints. etc. Best Execution and Operational Performance Sponsored by CACEIS. and objectives of the private banking clientele. sponsored by BNP Paribas Investment Partners and the "Private AssetLiability Management" research chair. “Passive” replication of “active” hedge fund indices through portfolios of derivative instruments is a key area in the research carried out by EDHEC. ALM and Asset Management Sponsored by BNP Paribas Investment Partners. in longterm portfolio management. sponsored by CACEIS. NYSE Euronext.). This programme includes the “Structured Products and Derivatives Instruments” research chair sponsored by the French Banking Federation. listed derivatives. EDHEC also proposes an original proprietary style index construction methodology for both the traditional and alternative universes. It also aims to develop an ALM approach addressing the particular needs. The goal of the research programme is to develop a complete framework for measuring transaction costs: EBEX (“Estimated Best Execution”) but also to develop the existing framework for specific situations (constrained orders.Hedge Fund Reporting Survey . such as hedge funds. Its main focus is on analysing the quality of indices and the criteria for choosing indices for institutional investors. AXA Investment Managers and ORTEC Finance This research programme focuses on the usefulness of employing derivative instruments in the area of portfolio construction. EDHEC launched the first composite hedge fund strategy indices. This programme includes the “MiFID and Best Execution” research chair. and SunGard. sponsored by AXA Investment Managers. more generally. analysis of market This research programme concentrates on the application of recent research in the area of asset-liability management for pension plans and insurance companies. in partnership with ORTEC Finance. the “Asset-Liability Management and Institutional Investment Management” research chair. and SunGard This research programme deals with two topics: best execution and. The research centre is working on the idea that improving asset management techniques and particularly strategic allocation techniques has a positive impact on the performance of asset-liability management programmes. This programme includes the “Regulation and Institutional Investment” research chair. The programme includes research on the benefits of alternative investments.November 2008 About the EDHEC Risk and Asset Management Research Centre classes. the impact of explicit and implicit transaction costs on portfolio performances. SGCIB and the French Banking Federation impact and opportunity costs on listed derivatives order books. NYSE Euronext. Asset Allocation and Derivatives Sponsored by Eurex. whether it involves implementing active portfolio allocation or replicating indices. An EDHEC Risk and Asset Management Research Centre Publication 67 .

The EDHEC PhD in Finance The PhD in Finance at EDHEC Business School is designed for professionals who aspire to higher intellectual levels and aim to redefine the investment banking and asset management industries. MiFID and Best Execution In partnership with NYSE Euronext. Asset-Liability Management and Institutional Investment Management In partnership with BNP Paribas Investment Partners The chair adapts risk budgeting and risk management concepts and techniques to the specificities of alternative investments. Private Asset-Liability Management In partnership with ORTEC Finance The chair examines advanced asset-liability management topics such as dynamic allocation strategies. rational pricing of liability schemes. and CACEIS Investor Services The chair will focus on the benefits of the asset-liability management approach to private wealth management. It is offered in two tracks: a residential track for high-potential graduate students who will hold part-time positions at EDHEC Business School. Structured Products and Derivative Instruments Sponsored by the French Banking Federation (FBF) The chair consists of academic research that will be devoted to the analysis and improvement of dynamic allocation models and new forms of target funds.Hedge Fund Reporting Survey . both in the context of asset management and asset-liability management. SunGard. Drawing its faculty from the world’s best universities and enjoying the support of The chair investigates the optimal design of structured products in an ALM context and studies structured products and derivatives on relatively illiquid underlying instruments. with particular attention being given to the life cycle asset allocation topic. and an executive track for practitioners who will keep their full-time jobs.November 2008 About the EDHEC Risk and Asset Management Research Centre Seven Research Chairs have been endowed: Regulation and Institutional Investment In partnership with AXA Investment Managers Financial Engineering and Global Alternative Portfolios for Institutional Investors Sponsored by Morgan Stanley Investment Management The chair investigates the interaction between regulation and institutional investment management on a European scale and highlights the challenges of regulatory developments for institutional investment managers. 68 An EDHEC Risk and Asset Management Research Centre Publication . Dynamic Allocation Models and new Forms of Target Funds for Private and Institutional Clients In partnership with Groupe UFG The chair looks at two crucial issues linked to the Markets in Financial Instruments Directive: building a complete framework for transaction cost analysis and analysing the consequences of market fragmentation. and formulation of an ALM model integrating the financial circumstances of pension plan sponsors.

The Centre’s activities have also given rise to the business offshoots EDHEC Investment Research and EDHEC Asset Management Education.stylerating.com). They look at the application of recent research advances within investment management companies and at best practices in the industry. conducts regular industry surveys and consultations.edhec-risk. www. The risk-adjusted performance of individual funds is used to build the Alpha League Table. www. Survey results receive considerable attention from professionals and are extensively reported by the international financial media.Hedge Fund Reporting Survey . and measuring performance persistence.November 2008 About the EDHEC Risk and Asset Management Research Centre the research centre with the most impact on the European financial industry. Research for Business To optimise exchanges between the academic and business worlds. the first ranking of European asset management companies based on their ability to deliver value on their equity management.edhec-risk. circulates a monthly newsletter to over 200. EDHEC Asset Management Education helps investment professionals to upgrade their skills with advanced risk and asset management training across traditional and alternative classes. the EDHEC Risk and Asset Management Research Centre maintains a website devoted to asset management research for the industry: (www. a free rating service for funds distributed in Europe which addresses market demand by delivering a true picture of alpha.com An EDHEC Risk and Asset Management Research Centre Publication 69 .000 practitioners. Recent industry surveys conducted by the EDHEC Risk and Asset Management Research Centre The EDHEC European ETF Survey 2008 sponsored by iShares The EDHEC European Investment Practices Survey 2008 sponsored by Newedge EDHEC European Real Estate Investment and Risk Management Survey 2007 sponsored by Aberdeen Property Investors and Groupe UFG EuroPerformance-EDHEC Style Ratings and Alpha League Table The business partnership between France’s leading fund rating agency and the EDHEC Risk and Asset Management Research Centre led to the 2004 launch of the EuroPerformance-EDHEC Style Ratings. accounting for potential extreme loss. Industry surveys: comparing research advances and industry best practices EDHEC regularly conducts surveys on the state of the European asset management industry. The site examines the latest academic research from a business perspective. and provides a critical look at the most recent industry news. and organises annual conferences for the benefit of institutional investors and asset managers.com EDHEC-Risk website The EDHEC Risk and Asset Management Research Centre’s website makes EDHEC’s analyses and expertise in the field of asset management and ALM available to professionals. the EDHEC PhD in Finance creates an extraordinary platform for professional development and industry innovation.

hedge fund start-up services.rated institutions yet remain independently managed and regulated. Newedge is committed to transparency. multi-disciplinary. are based on mutual respect. Newedge offers a global range of brokerage activities on a wide range of asset classes including equities. integrity and rigorous ethical standards. Newedge works in a 70 An EDHEC Risk and Asset Management Research Centre Publication spirit of partnership.Hedge Fund Reporting Survey . hedge fund industry quantitative information and capital introductions services. 2008. Newedge is a global organization and has access to more than 80+ global derivative and stock exchanges. Our independence from the trading activities of the two banks minimizes potential conflicts of interest. This makes Newedge unique among prime brokers: we are supported by these two AA. The team also provides a dedicated account management team. Newedge Group (UK Branch) 10 Bishops Square London E1 6EG Tel. +44 (0) 207 676 85 36 Fax +44 (0) 207 676 81 45 www. cross-margining tools between securities & derivative instruments. valued contribution. resulting from the merger of the two brokerage firms – Calyon Financial and Fimat – on January 2nd. Our role as a dedicated broker combined with our unique governance model help us minimize conflicts of interest. and their related listed & OTC derivative products.000 employees in 26 of the world’s top financial centers. bonds. currencies. Relations with our customers. Newedge is a major new force in finance.newedgegroup. teamoriented solution-providing organisation dedicated to delivering superior services to alternative investment industry participants such as investors and fund managers. and trust. With over 3.com/primebrokerage .November 2008 About Newedge Global Prime Brokerage Newedge Global Prime Brokerage group is a global. commodities. and between our multinational teams.

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com Hong Kong: Kirby Daley +852 2848 3368 Singapore: Yves Marcel +65 63497530 Paris: Frederic Lefevre +33 1 5507 3567 London: Duncan Crawford +44 (0)20 7676 85 04 New York: Jonathan Gane +1 646 557 7966 E-mail: pbinfo@newedgegroup.: +33 (0)4 93 18 78 24 Fax: +33 (0)4 93 18 78 41 E-mail: research@edhec-risk.EDHEC Risk and Asset Management Research Centre 393-400 promenade des Anglais BP 3116 06202 Nice Cedex 3 .com Web: www.France Tel.edhec-risk.com .

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