By Donald A. Steinbrugge, CFA – Founder and CEO, Agecroft Partners
As we thoroughly mentioned in the first part of this in-depth article, the Chartered Financial Analyst Institute (CFA), one of the most important organizations in the investment industry, is expected to announce performance presentation standards for the hedge fund industry sometime later this year. And here, after having gone through the most important issue that needs to be addressed is standardizing how to calculate and present a hedge fund’s net performance in the first entry, we are going to explain in detail what other issues the CFA institute should look at in their most anticipated announce later this year.
Wrapping up a bit, the CFA Institute is still formulating their recommendations and we applaud their efforts. Ideally, these standards should benefit hedge fund managers by leveling the playing field on which they compete, as well as investors, by providing consistent information that will enhance their investment decision making process. It is extremely important that the CFA Institute achieves both objectives in order to have broad adoption across the industry. Now is the time for the hedge fund industry to speak up.
In this second part, Agecroft Partners feels compelled to share our updated views on what we expressed earlier this year in an educational video hosted at the CFA Institute.
Issues that should be addressed include:
Security valuation guidelines. Performance disclosures should describe how valuations are determined and whether or not there is any third party validation of their accuracy. The disclosure should also describe the liquidity of the underlying investments in the fund. Many investors are attracted to less liquid securities because they often provide greater upside from pricing inefficiencies (in addition to an illiquidity premium). It is important to note that the valuation of less liquid securities can, at times, artificially smooth out return streams. This will, in turn, reduce the standard deviation of returns, increase Sharpe ratios, distort correlations, and understate potential tail risk. All of these statistics are among those used by investors in selecting hedge funds.
Expenses allocated to the fund. These expenses can have a large impact on net performance and should be disclosed in greater clarity. There is a broad range across the hedge fund industry of what expenses are allocated to a fund. While DDQ’s typically articulate broad categories of expenses, they lack the granularity required for investors to really understand what fees they’re paying. We believe investors should receive the fund’s expense ratio along with full disclosure on what type of expenses are being allocated to the fund. This is particularly important to onshore investors who can no longer deduct fund expenses. With greater clarity, more hedge funds are likely to take a conservative approach to expense allocation and thereby increase net returns to investors.
Assets under management used to calculate performance. Most hedge fund strategies have asset capacity limitations beyond which performance will be negatively impacted. In an environment where most assets are flowing to the largest funds, investors need to see how a fund’s growth over time impacts performance.
How to handle performance for Separate Accounts and Funds-of-One. Twenty years ago, most hedge fund industry assets were invested in commingled funds, with the exception of assets invested in commodity trading advisors (CTA’s). Today, separate accounts and “funds of one” are much more common for large investors. We are not in favor of a single composite performance for a hedge fund organization with multiple funds and/or accounts. However, investors should know if there are performance differences between investments in the commingled fund, and those in managed accounts and funds-of-one, and if so, why. This might be addressed by using Global Investment Performance Standards (GIPS), which was created by the CFA Institute for long only investment organizations. We could envision GIPS being applied to the separate accounts and fund-of-one assets of the hedge fund organization.
Simulated track records. There are broad differences in how simulated track records are created and what they represent. There are simulated records reflecting actual performance but different fees. Some simulated records illustrate how a leveraged version of their current (unlevered) strategy might have performed. Some quantitative managers show simulated back tested performance, which many people believe has significantly less credibility than returns based on an actual portfolio. We believe a firm should be able to show simulated performance as long as it is clearly marked on the performance page (potentially highlighted in red) and consistently described in the disclosures based on new industry standards. One exception would be for a track record created since inception assuming all assets pay full fees (which would be footnoted, but not need to be clearly marked as “simulated” on the performance page.)
The Alternative Investment Management Association (AIMA) Due Diligence Questionnaire (DDQ). Hedge fund historical performance is one of many evaluation factors investors use to select a hedge fund. AIMA is a highly regarded organization within the hedge fund industry and, through their DDQ, has done a great job of standardizing how hedge funds communicate many issues that are important to investors. We believe the CFA Institute should leverage the work that AIMA has done by recommending in the performance disclosures that investors read both the hedge fund documents and an AIMA structured DDQ before investing.
Finally, in order to make performance disclosures easy to understand for the investor there should be a recommended format in which the various categories of disclosures are addressed. Additionally, where possible, we would support standardized language to ensure consistent communication across the industry.
All managers deserve a level playing field on which to compete. Investors need consistency in how performance is calculated and presented, with enhanced disclosure, in order to make the best possible investment decisions. The CFA Institute is composing performance standards for the hedge fund industry, which they expect to announce later this year. It is important the CFA Institute receives the best possible information to maximize the benefit of these upcoming performance standards for all stakeholders. This will increase the probability of these standards being broadly accepted throughout the hedge fund industry and thereby provide the much needed consistency that will benefit all market participants.
Check out the first part of this entry here.
About the author
Don is the Founder and CEO of Agecroft Partners, a global hedge fund consulting and marketing firm. Agecroft Partners has won 38 industry awards as the Hedge Fund Marketing Firm of the Year. Don frequently writes white papers on trends he sees in the hedge fund industry, has spoken at over 100 hedge fund conferences, has been quoted in hundreds of articles relative to the hedge fund industry and has done over 100 interviews on business television and radio.
Don is also chairman of Gaining the Edge-Hedge Fund Leadership Conference; consider one of the top conferences in the hedge fund industry. All profits from the conference are donated to charities that benefit children.
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