Over the last five years, a trail of disconcerting financial stories crept into the news, unsettling investors along the way:
- In 2006, Amaranth Advisors LLC, a hedge fund focused on energy trades, collapsed amidst plummeting natural gas prices.
- In 2008, federal regulators arrested Bernard Madoff and charged him with criminal securities fraud.
- Last April, the U.S. Securities and Exchange Commission (SEC) charged Goldman Sachs Group Inc. with investor fraud for allegedly misstating and omitting key facts from disclosures about a mortgage-backed investment offering.
These and other high-profile cases have sparked fresh calls for improved disclosure rules designed to increase transparency in such sophisticated investments.
For example, in the case of Amaranth, the San Diego County Employees Retirement Association sued its pension fund’s managers after it lost much of its investment. The association argued that comprehensive disclosure would have spotlighted the fund’s excessive leverage. As for Madoff, Harry Markopolos, who analyzed Madoff’s returns while working at another hedge fund, said deeper insight into long-term records of success would have uncovered falsified returns. Unfortunately, the SEC ignored his conclusions for nine years. In the Goldman Sachs case, the SEC said more extensive disclosure would have provided key information about the security’s composition.
Yet hedge funds have long avoided material disclosures, especially compared with the heavily regulated mutual fund industry. In turn, given the complexity of hedge funds and the underlying investments themselves, it may be likely that any disclosure measures face an uphill battle in the effort to provide “true” clarity.
“Transparency for the sake of transparency is not the panacea some think it is,” says Victoria Vodolazschi, CFA, Stamford, Conn.-based director of hedge fund investments with Northern Trust Global Advisors, which oversees a fund of hedge funds for Northern Trust clients. “But if you know how to put the disclosed information to good use, it can make a big difference in your portfolio’s performance.”
Varied Analyses from Varied Types of Disclosure
The conflict over disclosure rules can be summed up as such: Hedge fund managers are reluctant to disclose anything that reveals strategies, tactics or investments that could potentially erode a competitive advantage, Vodolazschi says. Regulators, however, believe improved disclosure rules will help them serve as the financial markets watchdog. Meanwhile, investors seek enough information to make informed decisions.
At least, that’s what investors say publicly. The truth of the matter is that many small investors gloss over or, worse, ignore dense disclosure documents. When they fail to fully assess and understand the potential risks to their capital, they may leave themselves open to potentially large losses.
Yet even for institutional investors, who employ professionals to wade through the maze of information, the often-complex data can present analytical challenges. “We [as investment professionals] want to know that managers are doing what they say they’re doing, that the book of investments has adequate liquidity and that we understand how much leverage is involved,” says Anthony Zanolla, CFA, a senior director of hedge fund investments with Northern Trust Global Advisors in Stamford, Conn. “But as there are different ways to value complicated holdings, and there’s no standard way to portray risk, we need to dig down into the fund and do the work to see what’s really going on.”
Ideally, Zanolla says his team receives “position-level” disclosure, a full accounting of each hedge fund’s long and short positions, derivatives and leverage profile. Such information is fed through a comprehensive analytical process that helps illustrate how much debt is being used, how that debt is being used and how liquid the hedge fund’s assets are, among other things.
An alternative to position-level disclosure is “third-party” analysis, conducted by firms contractually bound to protect raw hedge fund data but still provide fairly comprehensive risk assessments and allow for some comparisons between funds. Reports from such firms allow investors to gauge market, credit, liquidity and operational risks in a hedge fund without knowing what specific positions may be influencing the risk levels.
“Returns-level” analysis, which examines funds at the broad performance level, is another approach. As is the case with any analysis based solely on historical data, however, returns-level analysis is no predictor of future success.
“Since historical hedge fund returns are self-reported and little else must be disclosed, it’s virtually impossible to confirm the data,” says Nicole Boyson, an assistant professor of finance at Northeastern University in Boston.
Moreover, within the hedge fund world, a complete strategic changeover could occur every six months, which renders past returns essentially useless as a predictive tool, relative to the way the portfolio is positioned today. For example, the short equity positions that paid off for a hedge fund in early 2009 don’t likely resemble its current long positions in the least. Accordingly, it’s difficult to compare the returns in an apples-to-apples fashion, although that’s how an unaware investor may view them.
Fund of Hedge Funds Approach
In an effort to gain exposure to the hedge fund industry and diversify risk – without assuming the responsibility of monitoring individual hedge fund investments – some investors rely on the fund of hedge funds approach. This strategy consists of investing in a portfolio of different hedge funds instead of individual hedge funds or sophisticated securities. It’s a strategy offered by Northern Trust, whose actively managed portfolio consists of investments in 30 to 40 hedge funds at any given time and is overseen by a team of 10 investment professionals.
With the fund of hedge funds approach, “disclosure does help us. Even when a fund doesn’t provide all of the specifics we like to see, it can be used as a barometer for what should be going on, and [we can] use it to identify potential issues,” Zanolla says. “But that doesn’t negate the necessity for experience and expertise in analyzing these investments.”
Although the fund of hedge funds approach satisfies most investors, you may decide to find other investment opportunities on your own. Tread carefully and commit to understanding as much as possible about the investment. Should you land in a situation where you need to make a decision about a hedge fund, Zanolla says there are a handful of critical factors –particularly relevant to leverage and liquidity – that you should understand:
- Details on the fund’s risk exposure. Is the fund leveraged? How is that leverage defined? How is that leverage calculated? What is the exposure to derivatives? Are the derivatives exchange-traded, which offers third-party backing, or traded over-the-counter (OTC)? How much of the fund consists of long positions vs. short positions?
- Insight into the fund’s liquidation profile. How long would it take the fund to liquidate? What assumptions about market liquidity are inherent in that estimate? How many of the fund’s positions are exchange-traded, which tends to offer greater potential liquidity? How are the fund’s OTC positions priced and valued? How independent and thorough are the valuations?
Perhaps more importantly, an investor’s due diligence, or upfront research, is even more critical to assess a hedge fund investment opportunity, Vodolazschi says. Along with the information on the fund’s risk exposure and liquidation profile, valuable questions include:
- How much does the manager have invested in the fund?
- What percentage of the fund is held by the top two or three investors?
Essentially, if a fund manager has minimal personal money at risk, he or she may take careless gambles. At the same time, if one or two controlling investors pull out, anyone remaining will likely sustain deep losses.
“In some ways, the best risk management you can exercise is asking a lot of questions before you invest,” Vodolazschi says. “If you do that well, you end up further ahead in the information-gathering process, you’ve filtered out more of the noise and you’ve determined what is the key to the fund’s success.”
Another Arrow in the Quiver
As long as hedge fund opportunities were restricted to savvier investors, regulators maintained a “caveat emptor” philosophy. But as the investments have increasingly slipped into the mainstream, officials have vowed to protect less-sophisticated investors with new rules and regulations (see “Hedge Funds Emerge from the Shadows,” above).
Yet complete transparency into any investment is virtually unattainable, so investors are best served by realistic expectations around disclosures – both in what can be gleaned from what is reported and the likelihood that data disclosed in the future will be reviewed and analyzed on a regular basis.
“Can disclosure help me pick the next big winner? No. Past information, no matter how accurate it is, cannot predict future success,” Boyson says. “Can disclosure help me avoid some potential disasters? I think so.”
Securities products and services are offered by Northern Trust Securities, Inc., member FINRA, SIPC, and a wholly owned subsidiary of Northern Trust Corporation.
NOT FDIC INSURED / NO BANK GUARANTEE / MAY LOSE VALUE
The foregoing discussion is general in nature, is intended for informational purposes only and is not intended to provide specific advice or recommendations for any individual or organization. Because the facts and circumstances surrounding each situation differ, you should consult your attorney, tax advisor or other professional advisor for advice on your particular situation.
Hedge funds are speculative in nature and may use leverage or other aggressive investment practices. As a result, their returns may be highly volatile, and you may lose all or a portion of your investment in the fund.
