Monday, 16 November 2009

Lack of Transparency Traduced

One of the most commonly repeated fallacies about the hedge fund business is that it lacks transparency. I think the opposite: in many ways hedge funds provide much better information flows than long-only managers. Hedge funds cannot be easily sold, but are more often bought, and may only be bought by experienced and provenly-monied investors. So if someone is a qualified investor they can be in receipt of a plethora of information on a potential investment in a hedge fund.

The information flow is different at different stages, and is provided in several ways. In order to subscribe to a hedge fund investors are sent an offering memorandum or prospectus. They are usually sent a presentation document of some length, and most investors in hedge funds get to meet the manager of the Fund. He can answer their specific questions directly. When a potential investor decides that they are seriously interested in a hedge fund they will ask for a further set of information flows – portfolio snapshots and transaction lists to analyse, and the potential investor will ask for a completed due diligence questionnaire. The standardised due diligence questionnaires go into detail on the management company, business structure, ownership and resources of the investment advisor to the fund. The investment processes and risk management procedures are disclosed. The due diligence questionnaire can run to 40 pages once completed. Prior experiences and track records of the principals will be made available to a serious potential investor.

Once a potential investor subscribes and has capital in a hedge fund they receive other information to keep them abreast of developments in their fund. Typically hedge fund managers send out a monthly written communication (or "letter") to investors and potential investors. The letters - usually sent between 3 and 10 business days after month-end – contain a lot more analysis of activity and the portfolio than a long-only manager would provide. The letters from a hedge fund typically contain a breakdown of the portfolio by sector and geography and sometimes macro factor exposure. The largest sector and individual position exposures are disclosed. The use of cash and effect of current hedging is often given, and the liquidity of the portfolio is sometimes reflected in days-to-liquidate information. The portfolio risk is often described in exposure and VaR terms. Often the letters contain some P&L attribution and risk concentration information.

In addition to the letters, managers sometimes grant elective access to the portfolios they run via either the websites of their prime brokers and/or a third party risk measurement/attribution service like Measurerisk, or Riskmetrics. For investors that mimic a fund through a managed account, a further level of disclosure is available - the portfolio activity and exposures are then visible real-time. Portfolio managers of hedge funds now arrange conference calls for their investors, and podcasts and video links to keep their investors informed on a current basis and facilitate some interaction with the manager whilst not consuming too much of his or her time.

Contrast all the above with what an investor in an OEIC/UCITS receives for information flows – reports twice a year, months out of date, and with a low level of information and little analysis of either activity or the current investments/portfolio. The portfolio manager is extremely unlikely to be available to talk to a potential investor in an OEIC/UCITS, and the investor might find it difficult to get hold of a marketing person to quiz, nevermind the key decision-maker.

So qualified investors in hedge funds that display serious intention do not have issues of transparency with hedge funds. Only those who do not need access and legally cannot have access are excluded.

There are now dozens of funds that could be characterised as a half-way house between a hedge fund and a mutual fund or OEIC – absolute return funds. Major investment houses have started these funds to make available to retail investors some of the hedge fund investment strategies. The providers are hopeful they can offer products with the advantages of hedge funds in terms of scope of investment powers (wider than a long-only fund), but without some of the disadvantages of hedge funds (poorly regulated offshore domiciles, high fees and restrictive redemption terms).

I am disappointed that the onshore investment industry has not taken some lessons in communication from hedge funds: absolute return funds are producing manager letters, but they contain only pale shadows of the information shown in a hedge fund manager letter. Polar Capital is a quoted manager of long-only and hedge fund products, and has been running the UK Absolute Return Fund for 17 months. The monthly letter contains only monthly performance numbers and a graph of the same, plus six paragraphs of text – half looking backwards and half looking forwards. That I completely agree with the manager's outlook (given below) does not detract from the point that it exemplifies - investors in hedge funds get better transparency than investors in other forms of pooled investment.



We remain cautious over the near term outlook for global equity markets. The recent reporting season on the whole was better than expected, largely the result of both cost cutting and strong cash generation. Revenue growth remains subdued but largely stable. However, as we said last month, it’s better to travel than to arrive; the internal dynamics of the market are not encouraging and whilst sentiment indicators are far from extreme, we expect the market to drift lower over the coming weeks, which should provide a better entry point into stocks with less market risk attached. As we near the end of the year, who would have thought that global equity markets would have performed so strongly? Many investors who are sitting on decent profits, (and with November the last liquid month for trading) will want to avoid risking these profits and are likely to be nervous holders of risk assets going into year end. On balance, we therefore expect a period of heightened volatility with risks skewed to the downside. As they said in one of the Godfather movies, it’s time to ‘go to the mattresses’, meaning time for war. A battle between the bears and the bulls is likely to persist for a while, with plenty of ammunition for both sides of the argument.

The Fund is currently modestly net short on both a dollar and delta adjusted basis and is exhibiting an inverse correlation with the market. When we feel the risks to the downside have either materialised or passed, we will be quick to take up our exposure levels in order to capture the value we believe is inherent within our long book.

Philip Hardy, Polar Capital, 5th November 2009

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