French business school Edhec, has released research based on its recent international consultation process on implementing a new framework f...

French business school Edhec, has released research based on its recent international consultation process on implementing a new framework for funds of hedge funds reporting. This consultation process was predicated by research published in 2003 that showed that a very large majority of European hedge fund managers were serving their investors badly by issuing reports that were designed for investments in traditional asset classes and therefore lacked more detailed risk information. According to Edhec, these alternative managers have been using a mean variance structure that is totally inappropriate for alternative investments’ risk and return profiles and which did not inform investors of extreme risk and risk factors affecting the different returns of the hedge fund strategies in which the funds of funds are invested. Interestingly, despite what the study’s authors see as somewhat conflicting goals, investors and fund managers, were found to broadly agree on what does constitute relevant information for inclusion in reports. For instance, both investors and fund managers favoured monthly frequency with three major levels of aggregation, namely at the strategy group, strategy and fund levels, rather than requiring full transparency or disclosure funds of hedge funds single positions. The study said that although market participants are progressively adapting their analytical tools to the specific features of hedge funds, funds of hedge funds reports have room for improvement and should: · Properly inform investors about the quantum of risk. Indicators covering the whole spectrum of risk, namely normal risk (e.g. volatility), loss risk (e.g. maximum draw down) and extreme risks (e.g. modified Value-at-Risk) should be provided. Risk-adjusted performance indicators should also span these different definitions of risk so that investors can be provided with relevant information, whatever their risk preferences. The study found that 46 per cent of fund managers and 74 per cent of investors consider that a style Value-at-Risk should be disclosed to investors, whilst 37 per cent of fund managers and 48 per cent of investors favour disclosure of a Modified Value-at-Risk. In 2003, Edhec found that only 20 per cent of fund managers estimated Value-at-Risk in their reports. The Sharpe ratio remains essential for 77 per cent of fund managers and 79 per cent of investors, but the Omega ratio has increased dramatically in importance and is now required by 57 per cent of fund managers and 48 per cent of investors. In 2003, only 4 per cent of fund managers considered the Omega ratio to be important. · Disclose to investors as to the nature of risk. Investors should be provided with information on the key drivers of fund of hedge fund performance, for instance volatility risk, liquidity risk and credit risk so that they can properly understand the fund’s risk profile. It is only with this information that asset managers can integrate a fund into their global allocation process. This can be done with static or dynamic style and factor analysis.