Report Says Hedge Funds Becoming More Transparent

by Carla Johnson, Investors Offshore, London

14 January 2003

Florida hedge fund manager LJH has published a study of hedge fund transparency, saying that it is the only sure means for an investor to guard against unscrupulous or incompetent fund managers. LJH worries that the incentive schemes which most hedge funds use to reward their managers can lead to unwise investment decisions, and that mere disclosure of investment positions is not necessarily enough to ensure transparency.

LJH points out that many managers are actively against even disclosing their positions, since the knowledge that a fund is shorting a company may cause the target to behave differently, or to withhold information from the fund in question, saying: “The bottom line is that where there are costs involved in preparing and releasing information and where certain types of disclosure may reveal proprietary information, transparency must be managed.”

The study says that for the average investor, fund of fund investment may be the only good way of ensuring that adequate due diligence is being carried out. For the richer investor, separate accounts are one means of dealing with the problem - but many of the better hedge fund managers refuse to accept managed accounts.

Overall, however, LJH thinks that the move towards transparency is gaining momentum. Third party 'Value At risk' (VAR) systems have come into vogue, although their high cost has deterred many managers from adopting them, while investor use of VAR systems is hobbled by the unwillingness of managers to make their intentions clear even where positions themselves have been disclosed.

“Consider, for example, a distressed securities portfolio,” LJH says. “A routine VaR analysis of the senior notes held in the portfolio is likely to prove meaningless. It will not shed any light on a manager’s strategy and intentions. Unless a manager directly communicates his views and horizon for each security held, transparency is unlikely to be achieved even with the best analytical tools.”

LJH sees competitive disclosure of portfolio statistics, whether by the funds themselves or by 3rd party observers, as being a more effective way of securing a reasonable degree of transparency.

“The improving disclosure of hedge funds that we have experienced in recent months reflects not the pressure of impending regulation, but the quiet workings of a competitive capital market,” LJH says. “While regulators are debating standards of disclosure for hedge funds, competitive pressures are providing an incentive to disclose information voluntarily. Fund managers not willing to disclose are facing increasing penalties in the form of increasing difficulties in their ability to retain existing investors and to attract additional investments from hedge funds, institutional investors, and increasingly high net worth individuals.”

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