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Hedge Fund Reporting Survey

November 2008

An EDHEC Risk and Asset Management Research Centre Publication

in association with

Foreword ............................................................................................................... 3

Executive Summary ............................................................................................. 5 1. Introduction ...................................................................................................13

2. Background .....................................................................................................17 2.1 Hedge Fund Reporting: Importance, Challenges, and Regulation ................................................................................................. 18 2.2 Performance and Performance Risk Measures of Hedge Funds ................................................................................................. 22 2.3 Specific Issues with Hedge Fund Performance ............................... 29

3. Methodology and Data ................................................................................35 3.1 Methodology ............................................................................................... 36 3.2 Data ................................................................................................................ 36

4. The View of the European Hedge Fund Industry on Current Disclosure Practices ................................................................39 4.1 Hedge Fund Reporting: the Big Picture ............................................ 40 4.2 Key Indicators: Performance Indicators and Risk Measures ........ 43 4.3 Specific Hedge Fund Risks Reconsidered .......................................... 48

5. Conclusion ......................................................................................................55

References ...........................................................................................................59

About the EDHEC Risk and Asset Management Research Centre .........66

About Newedge Global Prime Brokerage .................................................... 70

Table of Contents

We are grateful to Stéphane Daul, Laurent Favre, Walter Géhin, Jean-René Giraud, Adina Grigoriu, Philippe Malaise, and Mathieu Vaissié for helpful comments. Any remaining errors are ours.

Printed in France, November 2008. Copyright EDHEC 2008.The opinions expressed in this survey are those of the authors and do not necessarily reflect those of EDHEC Business School.

3An EDHEC Risk and Asset Management Research Centre Publication

Hedge Fund Reporting Survey - November 2008

Since it was set up in 2001, the EDHEC Risk and Asset Management Research Centre has monitored practices in the European asset management industry. The Centre’s surveys on the state of the industry look specifically at the use of recent research advances and at best practices. These surveys have shed light on portfolio risk management, the use of indices and benchmarks, funds of hedge fund management, ETFs, alternative diversification, and real estate investment. In particular, EDHEC published a report on funds of hedge fund reporting practices in January 2005. In that document, we made the case that improved reporting would be useful to both investors and managers, and should not be seen only as a constraint by the latter.

The recent extraordinary events in financial markets are likely to increase investors’ needs for proper information disclosure. In particular, many hedge fund strategies have incurred significant losses, raising awareness of their exposure to various risk factors. Whether hedge fund managers should share information on such risk exposures with their investors, and how they should do so, is, as it happens, the focus of the EDHEC Hedge Fund Reporting Survey 2008. This survey has enabled us to compare industry practices, guidelines issued by industry bodies, and academic research into hedge fund performance and risk disclosure.

The survey is divided into two parts. The first part outlines the issues with hedge fund reporting and gives a brief review of the state of the art in performance and risk analysis for hedge fund investments. The second part presents the survey’s

findings on current industry practices and on the preferences expressed by investors and managers. Overall, the results suggest that investors’ requirements for hedge fund disclosure diverge considerably both from hedge fund managers’ perception of what is relevant and from guidelines and “best practices” published by industry bodies. In addition, today’s reporting still relies heavily on risk and performance measures that the academic literature has found unsuitable for hedge fund portfolios.

We are grateful to the many participants who have responded to our questions and without whom this survey would not have been possible. We would also like to express our appreciation to the authors of the survey, to Amélie Jean and Lucie Liversain, who helped distribute the questionnaire, and to the publishing team led by Laurent Ringelstein.

Finally, we would like to extend our most sincere thanks to our partners at Newedge Prime Brokerage, whose generous support of our research into information disclosure in the hedge fund industry has enabled this survey to be produced. We look forward to expanding our research in this area with Newedge Prime Brokerage's backing in the months and years to come, so that EDHEC can continue to provide the industry with state-of-the-art applied research.

Foreword

Noël AmencProfessor of FinanceDirector of the EDHEC Risk and Asset Management Research Centre

4 An EDHEC Risk and Asset Management Research Centre Publication


About the authors

David Schroeder is a senior research engineer at the EDHEC Risk and Asset Management Research Centre. David obtained his PhD in economics from the University of Bonn. During his doctoral studies, he was also affiliated with the Centre de Recherche en Economie et Statistique (CREST) in Paris. His research focuses on empirical asset pricing, the predictive power of equity analysts’ forecasts, and decision making under ambiguity. He is a member of the Econometric Society and has presented at many international economic and finance conferences.

Felix Goltz is head of applied research at the EDHEC Risk and Asset Management Research Centre. He conducts research in empirical finance and asset allocation, with a focus on alternative investments and indexing strategies. His work has appeared in various international academic and practitioner journals and handbooks. He obtained a PhD in finance from the University of Nice Sophia-Antipolis after studying economics and business administration at the University of Bayreuth and EDHEC Business School.

Executive Summary

5An EDHEC Risk and Asset Management Research Centre Publ icat ion



Like any investors, investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment, and whether this allocation yields positive returns or not. It is not only information on past investment returns that is of particular interest; prospects for future gains or losses are relevant to investors as well. Yet, unlike mutual funds, hedge funds are reluctant to provide detailed information on their investment portfolios. Since many hedge funds use highly speculative investment strategies, fund managers fear that a thorough disclosure of their portfolio holdings would significantly decrease their chances of winning their bets, and thereby reduce investors' returns. But incomplete disclosure can have some undesirable side effects. It might open the door for hedge fund managers to change their investment strategy or to include investments in the portfolio that are riskier than provided for by the managers' mandate. Investors even risk fraudulent behaviour, since the action of the hedge fund management might be detected only when a fund has failed. The remarkable rise of the hedge fund industry over the past decade has aggravated the problem. In the past, the typical hedge fund investor was a wealthy private client, but more recently institutional investors have increased their stakes in hedge funds considerably. These investors, such as pension funds or insurance companies, have more sophisticated investment objectives and therefore require greater disclosure, in part because they have to render accounts to their own investors. In this light, it is clear that hedge fund reporting can be a source of tension between investors and hedge fund management. The objective of this survey is to shed light on current industry practices in order to

establish an industry benchmark for hedge fund reporting in Europe.

The EDHEC Hedge Fund Reporting Survey is representative of the European hedge fund industryTo obtain a comprehensive view of industry practices, the EDHEC Hedge Fund Reporting Survey targets the three main professional groups of the European hedge fund business: hedge fund managers, fund of hedge fund managers, and hedge fund investors, all of which are equally represented in the survey. The survey participants are mainly medium-sized companies, with assets under management of between 100mn and 10bn EUR. However, some major firms with more than 100bn EUR in assets under management respond to the survey as well. Moreover, about half of the 214 survey respondents are high-ranking executives (CEOs, managing directors, CFOs). To shed light on hedge fund reporting, the survey contains sections devoted to issues of particular interest to hedge funds. Whereas the first set of questions asks more general questions on the importance of and satisfaction with current hedge fund reporting, the other sections address very specific topics, such as appropriate performance measures, liquidity and leverage risk indicators, or the difficulty of sensitive operational risk reporting. We present below the main results of this survey.

The quality of hedge fund reporting is an important indicator of a fund's overall excellence and thus a crucial investment criterionOne of the most important findings of this survey is that the hedge fund

Executive Summary



industry unambiguously believes that a fund's reporting quality is an indicator of the overall excellence of a hedge fund. Furthermore, we find that reporting quality is essential for investors' decisions to invest in a hedge fund. In fact, this study showsthat more than 70% of all investors have internal disclosure requirements that must be met before they invest in a hedge fund.

Is hedge fund reporting an important indicator for a hedge fund's overall quality?

Objectives of hedge fund reporting

Next, we examine what industry practitioners believe to be the main objectives of hedge fund reporting. Most practitioners think that the main

objective of hedge fund reporting is to assess the risk/return profile of the hedge fund under consideration. Risk information for the investors' total asset allocation and performance attribution are also considered important objectives of hedge fund disclosure.

Hedge fund managers are not aware of their clients' true information requirementsThe EDHEC survey reveals that hedge fund managers are not well informed of their investors' needs for information. We find that, in general, investors consider much more information relevant to risk assessments of a hedge fund than do managers of the hedge funds themselves. The figure below illustrates these results by presenting the perceived importance of components of hedge fund disclosure by professional group. As can be seen, the perceived importance of information differs most about information on liquidity risk, operational risk, and the portfolio composition of hedge funds, implying that investors wish to see much more disclosure on these issues than fund managers consider necessary. Other great differences are apparent when it comes to the qualitative outlook, risk-adjusted performance and the beta exposure of a fund. When the facets of risk and performance disclosure are compared, hedge fund managers think that information on risk-adjusted returns is relatively more important to investors. However, investors themselves regard this aspect as least important; they stress the relevance of information on past returns and extreme risks.

Executive Summary



What is important for a good hedge fund report?Answers by professional group

Finally, we also find that hedge fund managers use many risk and performance measures without disclosing them to investors, believing that their investors are uninterested in these additional indicators. Since hedge fund disclosure is designed to inform investors, this divergence in the views of what information is important is an obstacle to hedge fund investment.

Current hedge fund disclosure practices do not meet the demands of investors.

Hedge fund reporting—Wishes and realityAnswers by fund of hedge fund managers and investors

As a direct consequence of scarce information, current hedge fund reports do not satisfy the informational requirements of investors. Although hedge fund reports are perceived to provide consistent, clear, and sufficiently frequent information on past returns, many crucial issues of hedge fund risk are left unaddressed. The exhibit on the bottom of the opposite column illustrates some of the perceived shortcomings of hedge fund disclosure by opposing perceived importance with the perceived quality of aspects of hedge fund reporting. The scatter plot thus makes it possible to detect aspects of hedge fund reporting that are judged very important, but that do not yet comply with the investors' requirements (upper left part of the plot).

These missing aspects include—most important—information on a fund's liquidity risk, operational risks, and factor exposure. Other topics viewed as neglected in hedge fund reporting are information on leverage risk (53% of all responding investors are dissatised with leverage risk disclosure), and the valuation framework.

Hedge fund managers tend to overestimate the quality of their reportingThe EDHEC hedge fund reporting survey also presents evidence that many hedge fund managers overestimate the reporting quality of their funds. As the exhibit below shows, hedge fund managers view the information they disclose much more highly than do their investors. The gap between the managers' and investors' views of the quality of information on auditing and compliance with the fund's

Executive Summary



private placement memorandum (PPM) is particularly wide. There are similarly divergent views on the quality of reporting in general. Whereas almost all investors consider the information contained in hedge funds is sufficient to assess the reporting quality, more than half the managers disagree. In contrast, fund managers agree that their information disclosure on issues concerning valuation, or internal controls is insufficient.

Does hedge fund reporting provide investors with sufficient information on…? Answers by group

Inappropriate risk measures, performance indicators and reporting practices prevail in the hedge fund industryWe also find that inappropriate performance measures prevail in the hedge fund industry. The table below summarises some of these

problems. Although many empirical studies present evidence that the Sharpe ratio, for example, is not suitable for risk-adjusted hedge fund returns, many respondents still believe in this measure. Likewise, most of the funds that report factor exposure rely on standard linear factor models, though empirical research has shown that non-linear factor exposures play an important role in hedge fund returns. In addition, many industry participants want to see a hedge fund's alpha calculated with respect to a hedge fund index or a peer group of hedge funds. However, these techniques are appropriate neither as benchmark nor as a means of calculating a fund's abnormal return, since they are too crude and thus do not reflect all risks related to hedge fund investment. The smoothing of hedge fund returns as a result of illiquid assets is another critical point. Although academics have proposed adjustments to correct for overly smooth hedge fund returns, they are rarely used. Finally, a substantial fraction of survey respondents judge manager estimates to be a suitable way to price hard-to-value assets. This practice, however, might induce managers to misstate the returns of their hedge funds deliberately. In short, the hedge fund industry is still beset by many inappropriate reporting practices.

Executive Summary

Academic Literature Industry practices

Non-normality of hedge fund returns

Hedge fund returns are not normally distributed (Agarwal and Naik, 2004)

62% do not know how to test for non-normality68% prefer Sharpe ratio

Dynamic factor exposure of hedge funds

Linear factor models are not appropriate (Fung and Hsieh, 1997)(Amenc et al., 2008)(Garcia and de los Rios, 2007)

78% use linear factor models

Alpha analysis Should be based on factor models; peer groups inappropriate (Sharpe, 1991)

About 50% prefer peer group or HF index

Smooth returns due to illiquid assets Hedge fund returns are smoother thanthey ought to be (Getmansky et al., 2004)

Only 5% use return smoothing-robust measures

Overview: academic standards and current industry practices of hedge fund disclosure



Although guidelines and best practices for hedge funds have a great impact on industry practices, they fall short of providing sufficient guidance on disclosure for hedge fund managers

Information sources for good hedge fund reporting

When comparing the information required by investors with the guidelines and best practices as issued by industry associations

and professional organisations (such as the Alternative Investment Management Association, Hedge Fund Standards Board, and others), our study finds remarkable shortcomings. Although these guidelines are the most important information source for the hedge fund industry (see the figure opposite), and thus have a great impact on the hedge fund industry, they rarely provide guidance on sound hedge fund disclosure. As the table below shows, many of these guidelines are very vague and cover topics where there is already standard disclosure, such as about the general hedge fund structure or information on past returns. Hence, these best practices fall short of encouraging hedge funds to provide information on very important aspects of hedge fund risks. Guidelines for disclosure of a fund's risk-adjusted returns, extreme risks, leverage and liquidity risk, or its factor exposure are given especially short shrift.

Executive Summary

Alternative Investment

Management Association

(AIMA)

Hedge Fund

Standards Board (HFSB)

Managed Funds

Association (MFA)

President's Working

Group (PWG)

InternationalOrganizationof Security

Commissions(IOSCO)

Reporting style (consistency, frequency, etc.)

+ + + o

Valuation framework + + o o +

Past returns o o + o

Extreme risks o

Factor exposure o

Portfolio composition

Leverage risk o o o

Liquidity risk o + o

Hedge fund structure (legal, management, etc.)

o + + +

Operational risk + + +

Guidance of industry "best practices" on optimal disclosure of hedge funds

o Topic mentioned in the guideline+ Detailed advice in the guidelineThe upper panel contains the components of hedge fund reporting deemed to be very important by investors following the analysis presented in exhibits 8, 39, and 42 of this document, the lower panel those which are deemed less important. A circle (o) signifies that the respective guidance mentions the corresponding issue, a plus (+) indicates that it contains detailed advice for this kind of risk disclosure. Note that the report by IOSCO is meant to cover the valuation of hedge funds only. A more detailed discussion of these guidelines is contained in section 2.1.



ConclusionThe results of this survey have a number of implications for the hedge fund industry. First, great differences between hedge fund managers' perception of relevant information disclosure and their investors' needs suggest that the industry should expand overall disclosure. Although there might be good reasons not to disclose, in great detail, the portfolio composition of hedge funds, many other aspects for risk reporting could be easily improved without putting a hedge fund's investment strategy in danger. Second, hedge funds should move to more appropriate risk and performance measures when disclosing their returns to investors. A large body of academic literature shows that many prevailing risk measures are unsuitable for reporting the true economic risks of hedge fund investment. The problem is not that there are no meaningful indicators, but that they are not actually used. Finally, the evidence on hedge fund reporting practices suggests that current guidelines and best practices of industry associations are unlikely to boost hedge fund transparency, and thus investor confidence. Guidance on optimal disclosure of a fund's risk-adjusted returns, extreme risks, leverage and liquidity risk, or its factor exposure is often neglected. To ensure greater hedge fund transparency, existing guidelines should be extended to cover these risks as well. It is important to note that this statement should not be misinterpreted as a call for more regulation of the hedge fund industry. Nonetheless, better reporting is likely to benefit all those involved in the industry.

Executive Summary



Executive Summary

1. Introduction




Like any investors, investors in hedge funds are naturally interested in knowing how hedge fund managers allocate their initial investment, and whether this allocation yields positive returns or not. It is not only information on past investment returns that is of particular interest; prospects for future gains or losses are relevant to investors as well. Yet, unlike mutual funds, hedge funds are reluctant to provide detailed information on their investment portfolios. Since many hedge funds use speculative investment strategies such as short selling, fund managers fear that a thorough disclosure of their portfolio holdings would significantly decrease the chances of winning their bets, and thereby reduce the investors' returns.1 But incomplete disclosure can have some undesirable side effects. It might open the door for hedge fund managers to change their investment strategy or to include investments in the portfolio that are riskier than provided for by the managers' mandate. Investors even risk fraudulent behaviour, since the action of the hedge fund management might be detected only when a fund has failed.

In this light, it is clear that hedge fund reporting can be a source of tension between investors and hedge fund management. In many economic frameworks, such conflicts of interest are solved by government regulation, as is the case for standard mutual funds, which are subject to detailed disclosure rules. However, these rules do not apply to hedge funds. In essence, the hedge fund industry is not regulated, and consequently hedge fund reporting is not subject to legislative rules, leaving the conflict with the investors and managers. The remarkable rise of the hedge fund industry over the past decade has aggravated the

problem. In the past, the typical hedge fund investor was a wealthy private client, but more recently institutional investors have increased their stakes in hedge funds considerably. These investors, such as pension funds or insurance companies, have more sophisticated investment objectives and therefore require greater disclosure, in part because they have to render an account to their own investors. Although recent years have seen attempts to create standards for voluntary hedge fund reporting, there is as yet no industry agreement on hedge fund disclosure. The objective of this survey is then to describe current industry practices to establish a European benchmark for hedge fund reporting.

A substantiated view on the multiple facets of hedge fund reporting is essential to a better understanding of the conflicts between hedge fund managers and their investors. Only by detecting differences in the perception of hedge fund reporting on both sides of the equation, as it were, is it possible to surmount the existing barriers to hedge fund investment. Moreover, this survey aims to compare the status quo of hedge fund reporting with recent academic advances in the literature. The past ten years have seen a tremendous increase in the number of hedge fund performance and risk measures. Many of these new indicators have their strong points, but have also created confusion about the measures that should actually be used for hedge fund disclosure. It is our aim to bridge the gap between the theoretical arguments of financial economists and the needs of the practitioners. Finally, the results of this survey might serve as an industry benchmark for current reporting standards. After all, in the absence of

1. Introduction

1 - The disclosure of short positions can lead to dangerous counter-strategies by competitors; see Brunnermeier and Pedersen (2005). Regulators such as the SEC largely agree on this view (Cox, 2006), adding that such disclosure could harm market efficiency.



government regulation, the reporting quality of one's competitors can serve as a standard. Similarly, investors tend to ask for the same information. Hence, it is our hope that this study can be useful for all industry participants as a source of information on appropriate hedge fund disclosure.

The EDHEC Hedge Fund Reporting Survey was taken with the help of an online questionnaire sent to European professionals in the hedge fund industry. For a comprehensive view on current practices in the industry, the survey targets the three main professional groups ofthe hedge fund business: hedge fund managers, fund of hedge fund managers, and hedge fund investors. To shed light on hedge fund reporting, the questionnaire contained sections devoted to issues of particular interest to hedge funds. Whereas the first section asked more general questions on the importance of and satisfaction with current hedge fund reporting, the other sections addressed very specific topics, such as appropriate performance measures, liquidity and leverage risk indicators, or the difficulty of sensitive operational risk reporting.

We find that hedge fund reporting is primordial. 92% of all industry practitioners believe that the quality of hedge fund reporting is an important signal of a fund's overall quality, and thus pivotal for investors' decisions about hedge fund investment. However, information disclosure is not viewed as adequate by investors. Although they are satisfied with the information on past hedge fund returns, the information on their fund's liquidity and operational risk exposure is regarded as incomplete. Industry guidelines and codes

of best practices are very influential for practitioners' opinions of optimal hedge fund disclosure. About two-thirds mention these documents as the most important information source. This study also reveals that inappropriate performance measures predominate in the hedge fund industry. Although many empirical studies have shown that the Sharpe ratio, for example, is unsuitable for reporting risk-adjusted hedge fund returns (Lo, 2002), many respondents still trust it. Likewise, most funds that indicate their factor exposure to investors rely on standard linear factor models, though empirical research has shown that non-linear factor exposures play an important role in hedge fund returns (Fung and Hsieh, 1997, 2000). Finally, the survey shows that managers and investors have diverging views on the quality of current hedge fund reporting, their objectives and important components. Not surprisingly, hedge fund managers have rosier views of the quality of the information they disclose than do their investors. Fund managers, for example, believe that risk-adjusted returns are the most crucial performance measure. Investors, however, consider information on extreme risks far more important. Finally, hedge fund managers think that hedge fund reporting is important to advertise their funds or to act as a fund selection tool for investors. Investors, however, stress that hedge fund disclosure also helps to control the fund managers' behaviour.

This survey proceeds as follows. Section 2 first discusses the importance of hedge fund reporting in more detail and provides a short overview of the existing regulatory framework and reporting guidelines as issued by government working groups or

1. Introduction



industry associations. We then summarise the most important risk and performance measures and discuss other crucial risks hedge funds are generally exposed to.The survey methodology is presented in section 3. The results of the EDHEC Hedge Fund Reporting Survey are found in section 4, where we draw a comprehensive picture of the status quo of hedge fund reporting. Section 5 draws conclusions from the survey results.

1. Introduction

2. Background




Unlike mutual funds, hedge funds use dynamic investment strategies and enjoy a high degree of freedom with respect to the instruments that they can hold in their portfolios. In addition, they can engage in short selling of securities and use leverage. Consequently, alternative strategies are infinitely more complex than those of traditional funds. The complexity of hedge fund investments poses a challenge for analysis as required by adequate and comprehensive disclosure of returns. Although some of the key elements of hedge fund reporting can—in principle—easily be captured by appropriate indicators, others are of a much more qualitative nature and thus harder to formalise. This section serves as theoretical background to the EDHEC Hedge Fund Reporting Survey. We outline the major challenges for hedge fund reporting and review the tools available to report performance and the risks of hedge fund investments.

First, section 2.1 demonstrates both the importance and the challenges of hedge fund reporting, the existing regulatory framework, as well as guidelines and best practices issued by government working groups and industry associations. Section 2.2 takes a closer look at the performance and risk measures used in hedge fund reporting. Although some of the standard measures are widely used, they are not always suitable from a theoretical standpoint. Finally, section 2.3 examines specific issues that are of particular importance for hedge fund disclosure, such as leverage, liquidity, and operational risk.

2.1 Hedge Fund Reporting: Importance, Challenges, and Regulation

2.1.1 Motivation and challenges of hedge fund reportingIn an illustrative example, Foster and Young (2008b) show why detailed hedge fund reporting is indispensable—and difficult to achieve at the same time. They consider a hedge fund manager who sells options that pay their holders a specific amount of money in the event of a rare event.2 Then he invests the money obtained from selling the options and the collected hedge fund capital in treasury bonds—and does nothing. If he is lucky, the rare event does not occur over the lifetime of the option, and consequently his fund will yield a rather high rate of return—obtained from selling the options and the interest gained on the proceeds. In contrast, if the rare event occurs, investors incur a heavy loss. This hypothetical example makes clear why good hedge fund reporting is difficult: the mere disclosure of past returns may not be sufficient to reflect the underlying risk of a portfolio. In addition, even the more detailed risk reporting might not be helpful for investors: managers can in principle just add some noise trading to their major investment strategy to disguise the underlying bets.

The example raises the question of the possible means of increasing the confidence of hedge fund investors. In the remainder of this section, we describe some of the means of reducing informational asymmetries between investors and hedge fund managers.

2. Background

2 - Such an event can be a decline of the S&P500 by more than 20% in one year.



Detailed reporting The most important means of reducing asymmetries of information between hedge fund management and investors is detailed, consistent, and accurate hedge fund reporting. When key figures about past hedge fund performance, also called return-based reporting, are provided, investors have a comprehensive picture of the past risks and returns of their stakes. A comprehensive description of the most important performance and risk indicators is provided below (section 2.2). However, even very detailed reporting cannot entirely resolve the problems of hedge fund opaqueness. First, return-based hedge fund reporting is only backward looking. All information contained in hedge fund reports therefore contains valuable prospective information only when it is assumed that the future investment strategy and the investment environment will remain unchanged. The rapidly changing strategies of hedge fund managers and occurrences of spectacular hedge fund closures following sudden changes in the markets prove that these assumptions are often untenable (even if the manager has positive intentions). Another problem is the abundance of the proposed performance and risk measures.Academics constantly propose new indicators, thereby improving and complicating things at the same time. Eling and Schumacher (2007) argue that many of the proposed performance measures lead to highly correlated rankings of hedge funds. On the other hand, Do et al. (2005) point out that traditional measures, such as the Sharpe ratio, can be very misleading when evaluating hedge funds. Next, many of the hedge fund performance measures can be gamed by managers.

Examples of such techniques are provided by Goetzmann et al. (2007); empirical evidence is provided by Bollen and Pool (2007). Reported returns of hedge funds are often much smoother than their true returns. Thus, smooth returns may be a sign that a manager is gaming performance measures. This issue is discussed in more detail in section 2.3.2. Although Goetzmann et al. (2007) also propose performance measures that are manipulation-proof, they are rarely used. A potential solution to the problems related to the disclosure of past returns is so-called holdings-based reporting. Unlike return-based reporting, holdings-based reporting attempts to disclose the current holdings of hedge funds—which might, however, generate managerial opposition. We return to this reporting style in section 2.3.3.

Auditing and external platformsAnother means of building trust between hedge funds and their investors is to include independent third parties in the reporting process. Bringing in such outside parties to validate the reported figures can take place at different stages. One possibility is to run the hedge fund via a managed account which then carries out the trading activity as directed by the hedge fund manager. The managed account platform can thus provide investors with the required information. Another option is to rely on external platforms not to manage the hedge fund itself, but merely to calculate the risk and performance measures of the fund, which can then be forwarded to investors. Finally, a hedge fund can decide to let its reports be audited by a third party. Besides these external devices, hedge funds can

2. Background



also opt to implement internal controls, such as delegating the determination of a funds' net asset value to an independent administrator, to achieve greater reporting transparency. Since the involvement of third parties is seen as a very important step to reduce operational risk, we come back to this issue in section 2.3.6.

The involvement of third parties or internal controls is, however, no guarantee of the correctness of a report—it is only a step in that direction. As with any third party audit, there are conflicts of interest between hedge funds and the auditing firm, which can lead to suboptimal audit quality. Another drawback of hedge fund auditing is the great expertise required of auditing firms. Since the investment strategies used by hedge fund managers evolve very quickly, auditing sometimes has trouble in keeping up. Nevertheless, auditing seems to have some positive effects on reporting quality. Liang (2003) shows that audited funds have more coherent data in hedge fund databases, which can be interpreted as a sign of greater reporting reliability.

Hedge fund fee structureThe complex fee structure of hedge funds, with high performance fees and high water marks, might lead to the conclusion that hedge fund managers' fee structuresare designed to align the interest of managers and investors. Unfortunately, this is not so. Although fees mitigate the conflict of interests to some extent, Foster and Young (2008a) show that it is generally impossible to design an incentive scheme that makes it possible to distinguish between skilled managers and unskilled managers (including the

fraudulent manager of the introductory example). Hence, unskilled managers may successfully mimic the behaviour of good managers over a certain time period and thus earn high fees, without delivering any investment skill. In the light of the impossibility theorem, the fee structure of hedge funds does not seem to be a feasible means of increasing investor confidence.

To sum up, despite the many cited problems and caveats, hedge fund reporting remains the only sensible way to reduce information asymmetries and thus to create investor condence. Any hedge fund reporting system will have its drawbacks, but detailed information on the hedge fund performance audited by an independent third party seems to be a reasonable solution for investors. Finally, regulators or industry associations can play a role in creating generally accepted reporting standards. We turn to this issue in the following sections.

2.1.2 Existing regulation of hedge fund disclosureAlthough hedge fund disclosure is largely unregulated, hedge funds are subject to government regulations in many countries. Hedge funds that are registered in the US must comply with the country's generally accepted accounting principles (US GAAP). Many of the standards are concerned with valuation principles and thus do not affect hedge fund disclosure itself (e.g., FASB 157). However, the FASB statement 107 (Disclosures about Fair Values of Financial Instruments) imposes some regulations. In the UK, the FSA has decided to use a principle-based regulation instead of creating rules that specify exactly what is permitted or prohibited.

2. Background



Also, many regulations deal with aspects other than information disclosure. More recent attempts to regulate hedge fund disclosure in the US and the European Union have failed.3 A detailed overview of hedge fund regulation in other European countries has been made available by theEuropean Fund and Asset Management Association (2005).

2.1.3 Reporting guidelinesBesides existing government regulation, there have been many attempts to impose "best practices" or "sound guidelines" on the hedge fund industry. Some of these attempts have been made by government organisations and financial authorities, often with the aim of reducing systematic risks in financial markets by encouraging better hedge fund governance and detailed hedge fund reporting standards. In addition, associations of national hedge fund managers and industry initiatives have proposed best practice guidelines to

prevent further government regulation of the industry and to make things more difficult for the industry's black sheep. Table 1 provides an overview of the most important guidelines for hedge funds.

Many of the best practices are of a very general nature, and remain very undemanding. They do not spell out rules for hedge fund managers, but give a rather broad overview of what the hedge fund management should do to improve the governance of a fund. The sections on hedge fund disclosure are particularly vague and deal mainly with the general set up of hedge funds, as displayed in table 2. Minimum compliance with such recommendations is unlikely to give substantial help to investors, as Naik (2007) points out. Moreover, the multitude of guidelines is a challenge for hedge fund managers, since some of the points addressed in the best practices might be in conflict with each other,

2. Background

3 - In 2004, the SEC designed a new rule that would have required hedge fund managers to register as investment advisors and disclose many critical issues about hedge fund governance. However, in 2006, the US Court ofAppeals overturned the rule. In Europe, the European Commissioner for Internal Market and Services, CharlieMcCreevy, rejected the European Parliament's 2008 attempts to increase hedge fund regulation in Europe,arguing instead for self-regulation of the industry.

Date Region Name Organisation Content

2008 US Best Practices for the Hedge Fund Industry Asset Managers' Committee

PWGa Overarching guidelines for asset managers

2008 US Best Practices for the Hedge Fund Industry Investors' Committee

PWG Overarching guidelines for hedge fund investors

2007 US Sound Practices for Hedge Fund Managers MFAb Overarching guidelines for asset managers

2007 Europe Guide to Sound Practices for Hedge Fund Managers

AIMAc Overarching guidelines for asset managers

2007 International Principles for the Valuation of Hedge Fund Portfolios

OICV-IOSCOd Hedge fund valuation

2007 UK Guide to Sound Practices for Hedge Fund Valuation

AIMA Hedge fund valuation

2008 UK 28 Best Practice Standards HFSB/HFWGe Overarching guidelines for asset managers

Table 1: Best practices and guidelines for hedge funds

Note that this list includes only the most important best practices and guidelines. Many other countries have their own guidelines, such as the AIMA Australia, or the FSA Dubai. In addition, there are other standards for risk management practices that are not specifically designed for hedge funds, such as those of the Risk Standards Working Group, the CFA, or the Investor Risk Committee.aPresident's Working Group on Financial MarketsbManaged Funds AssociationcAlternative Investment Management AssociationdInternational Organization of Securities CommissionseHedge Fund Standards Board/Hedge Fund Working Group



reflecting differences in market practices in the US and Europe. But most sets of guidelines are similar, so compliance with one set often implies compliance with the others.4

Another difference between the various best practice standards is the enforcement of these standards. The newly issued best practices of the Presidents Working Group (PWG) are completely voluntarily, the aim being merely to create a benchmark for hedge fund managers. The Hedge Fund Working Group's (HFWG) Best Standards, by contrast, attempt to establish a "comply or explain" practice, meaning that non-complying funds are expected to explain why they are not doing so. However, it is not clear whether and how this practice could be enforced.

The future is likely to see more guidelines on valuation and disclosure for hedge fund managers. Last year, the Global Investment Performance Standards (GIPS) announced that they would extend their framework to include hedge funds by 2010. It is to be hoped that existing and new proposals will converge over time to an internationally accepted standard.

Clear rules for hedge fund disclosure, either by government regulation or by industry standards, can have many advantages. Investors are better informed, and more important, are equally well informed—thereby eliminating the advantages privileged investors have at the expense of others. Fund managers will appreciate a set of clear and simple rules that they can expect to satisfy authorities and investors across the globe. Likewise, regulators benefit from a unified disclosure framework, allowing them to better assess the overall risks involved in hedge fund investments.

2.2 Performance and Performance Risk Measures of Hedge FundsLike any investor, the typical hedge fund investor is risk-averse, i.e., he has a preference for high returns, but dislikes the risk related to his investment. All risk and performance risk measures thus attempt to satisfy the investor's needs to be informed about the returns, but also about the related risks he bears. Some measures, like return analysis, focus on the return component; others, such as extreme risk analysis, try to capture the riskiness of the hedge fund investment.

2. Background

4 - In October 2008, major hedge fund organisations set up an internet site where different guidelines can easilybe compared. This overview is available at: www.hedgefundmatrix.com.


Requirement Description/Example

PPM Existence of a private placement memorandum

Counterparties Disclosure of counterparties and third parties on request

Strategy of the fund Style, permissible investment, use of leverage, regional exposure

Key management Names and vita of the hedge fund management

Conflicts of interest Managers running several hedge funds

Conflicts between investors Disclosure on side letters and parallel managed accounts

Legal framework Hedge fund structure, including fees and redemption rights

Timely disclosure Disclosure of past hedge fund performance at regular intervals

Valuation framework Detailed description of the valuation framework

Table 2: Common standards for hedge fund disclosure



Finally, risk-adjusted performance measures and factor analysis combine both dimensions of any investment by relating return and risk to each other.

The literature on stocks and mutual funds has proposed an abundance of measures that can be used to measure the risk and return of these investments. The crucial question is whether these risk indicators can be similarly used for hedge fund portfolios. The first works to analyse hedge fund risk and performance, including the papers by Elton, et al. (1987), Brown, et al. (1999), and Ackermann, et al. (1999), draw on these standard measures to determine whether hedge funds perform better than the market or not. However, as subsequent works by Agarwal and Naik (2000c), Fung and Hsieh (2001), Lo et al. (2001, 2002) have shown, hedge funds exhibit some particularities that make them very different from standard equity investments. First, hedge fund returns— as opposed to mutual fund returns—are not normally distributed. Second, they are non-linear with respect to the standard market factors, such as equity and bond markets. Indeed, hedge funds often modify their investment style so that their exposure to risk factors is highly dynamic over time. These differences make the standard risk and return indicators—although still widely used—inappropriate for hedge funds.

In this section, we briefly describe the most important performance and performance risk indicators used in hedge fund reporting. Lhabitant (2004), Amenc, et al. (2005) and Géhin (2006) provide more comprehensive surveys on most of the

measures currently used by hedge funds. Le Sourd (2007) reviews the measures aimed at traditional investment universes, but used by hedge funds as well.

2.2.1 Analysis of hedge fund returnsAn initial assessment of hedge fund returns usually involves the analysis of past hedge fund returns using descriptive statistics and statistical tests. Simple to calculate, it is the basis of any hedge fund reporting and is by far the most informative to investors.

Returns, return persistence, and volatility Past hedge fund returns are without doubt important information. Standard presentations include monthly and annual returns—net of fees—in absolute terms, and relative to a benchmark.5 Sinceinvestors are less concerned with past returns than with future returns, persistence measures are important as well. Gain frequency, calculated as the percentage of positive monthly returns is an initial indicator of performance persistence. Closely related, but more complicated to calculate, is the Hurst (1951) coefficient. Finally, the volatility of monthly returns is an initial assessment of the riskiness of the hedge fund. Simpler, but equally informative measures of a hedge fund's volatility are minimum and maximum past monthly returns, or—more generally—their upper and lower deciles (or quartiles).

Downside risk There are also some key figures that help to assess the downside risk of returns—an issue of particular interest to hedge fund investors. The maximum past drawdown

2. Background

5 - The calculation of past returns is not as simple as it seems, since it is preceded by the determination ofthe hedge funds' value, an issue which is tackled again in section 2.3.6. Moreover, there are several ways tocalculate the returns. For more detail, see chapter 2 of Lhabitant (2004).



is a simple but informative indicator of downside risk. The skewness and kurtosis of fund returns are together important in assessing downside risk: a return distribution that is negatively skewed combined with positive (excess) kurtosis is a strong indicator of high downside risk. Semi-deviation and other lower partial moments of hedge fund returns are similarly useful. Finally, hedge fund returns during extremely negative equity markets are a good measure of a fund's ability to hedge downside stock market movements.

Non-normality and autocorrelation of hedge fund returnsInformation can also be had by applying statistical tests to the hedge fund returns. Statistical tests, such as the Jarque-Bera test (Jarque and Bera, 1980), make it possible to assess the normality of hedge fund returns. If normality is rejected, the fund is likely to exhibit a larger downside risk than standard equity investments. Tests of autocorrelation, such as the Ljung-Box test (Ljung and Box, 1978), are generally used to detect the fraction of illiquid assets in the hedge fund portfolio. If the test of no autocorrelation is rejected, the portfolio is likely to contain a large fraction of illiquid and thus hard-to-value assets. Consequently, return figures must be treated with caution. Since both issues are of special interest for hedge fund reporting, we come back to them in sections 2.3.1 and 2.3.2.

2.2.2 Extreme risk measuresBecause of their non-normal return structure and thus higher relatively higher downside risk, simple volatility

measures underestimate a fund's riskiness. It is therefore crucial to assess the hedge fund's risk of extremely negative returns.

VaR and related measures. Value-at-Risk (VaR) is perhaps the most important extreme risk measure. The VaR of a portfolio is the maximum amount of capital that can be expected to be lost within a specific time period (usually one month), given a specified confidence level (usually 95% or 99%). There are several ways to calculate VaR. The simplest is to assume a normal distribution of returns, which must be estimated to calculate the expected maximum loss. Since hedge fund returns are usually not normally distributed, an alternative is to use non-parametric estimation based on the historical distribution of hedge fund returns. In this way, the non-normality is captured automatically. Another approach uses Monte-Carlo simulation techniques to estimate the expected maximum loss. Such simulations can assume either normally distributed returns or more complex distributions that account for the asymmetry and fat tails of hedge fund returns.

Besides the standard VaR, there are more sophisticated VaR measures that attempt to meet the needs of hedge fund reporting. The so-called Cornish-Fisher VaR (Favre and Ranaldo, 2002)—also called modified VaR (MVaR)—is an extension of the standard VaR that incorporates the effect of skewness and the fat tails of hedge fund returns. Incremental VaR (Jorion, 2001) attempts to measure the change in VaR when a particular asset class is introduced to the portfolio. Closely

2. Background



related, component VaR, described by Jorion (2001), indicates the contribution of a specific asset to the VaR of the overall portfolio. Conditional VaR (also called expected shortfall) is another extension of the VaR approach. Compared to the VaR, it does not specify the maximum expected loss for a specific confidence level, but the average amount of loss if that significant loss actually occurs. Conditional VaR is thus very important if the distribution of returns has very fat tails, since the loss might be much larger than that specified by VaR.6 Applications of the conditional VaR to hedge funds are by Agarwal and Naik (2004) and De Souza and Gokcan (2004). Finally, shortfall probability can be considered the inverse of VaR: instead of estimating the maximum loss given a confidence interval, the shortfall probability indicates the probability that a given loss will actually to occur.

Another method of calculating a VaR estimate relies on style analysis, the so-called style VaR (Lhabitant 2001, 2004). This method first examines the relationships of the investment styles in the portfolio,7 then analyses the impact of the worst variation of each style on the portfolio. Laporte (2003) proposes an extension of the style VaR to include liquidity risk borne by hedge fund investors through lock-up constraints.8 By adding an additional factor to the style VaR, this model facilitates analysis of the impact of such clauses on a fund's VaR. Finally, it is important to mention the extreme value theory (EVT)(Embrecht et al., 2008; Lhabitant, 2004). Actually, it is not a variant of VaR, but an important tool to calculate it. EVT simply focuses on the modelling of the tails of a distribution,

leaving the rest unspecified. However, since rare negative events are of great importance for hedge funds, this tool makes it possible to evaluate the risks related to such events. The distribution of the tail can then be used to estimate the VaR.

Stress testsBesides the different VaR approaches, hedge funds often use stress tests to assess extreme risks. Unlike the VaR, stress testing requires no assumptions on a fund's return probability distribution and is therefore essentially a non-statistical risk measure. It relies instead on Monte-Carlo techniques to evaluate the impact of extreme but probable situations on hedge fund performance. The crucial difference from VaR and EVT is the stress test's ability to simulate shocks that have never occurred in the past, or which are more likely to occur than historical evidence suggests. Stress tests can also be used to analyse the impact of structural shocks to the financial system on hedge fund returns. The basic idea of stress tests is simple: evaluating the impact of sudden changes in the determinants of hedge fund returns on their performance. Such stress tests can simulate either the consequences of changes in one particular key variable (also called sensitivity testing) on hedge fund performance or the impact of an extreme variation in many critical factors (called multidimensional scenario analysis). Stress tests can simply assume a one-shot deviation from the variables under consideration or they can involve more complicated models that reflect the impact of so-called spiral effects (second round effects) on hedge fund performance.9

2. Background

6 - Strictly speaking, conditional VaR and expected shortfall are two different concepts. Conditional VaRcalculates the expected shortfall given a pre-specified condence level, whereas the expected shortfall can alsobe calculated using another loss limit.7 - See section 2.2.4 for more details on style analysis8 - This is an important difference to the general notion of liquidity risk, which usually denotes the liquidityrisk within the hedge fund.9 - See Jorion (2001) for a detailed review of stress testing.



2.2.3 Risk-adjusted performance measuresSections 2.2.2 and 2.2.1 present measures to analyse both hedge fund returns and their related risks. The most interesting parts of hedge fund reporting, however, are indicators that combine both analyses, because above-average returns are not a surprise when running high-risk strategies. The real challenge is to deliver good performance while limiting risk exposure. Risk-adjusted performance measures are designed to detect investments that have a good risk/return trade-off.

Sharpe ratio and related measures. The Sharpe (1966) ratio is the most famous measure of return to risk. It is the ratio of the portfolio's expected excess return over the risk-free rate E[rp] - rf and its standard deviation σp:

(1)

The higher the Sharpe ratio, the better the risk-return trade-off. Intuitively, it can be interpreted as a fund's excess return per unit of risk. In fact, apart from slight modications, all risk-adjusted performance measures follow this principle by relating returns to units of risk. Almost three decades after the Sharpe ratio, Sharpe (1994) proposed a generalisation of his original ratio, the so-called information ratio (IR). It is the ratio of the portfolio's excess return over that of another portfolio (usually a benchmark) and the standard deviation of the return difference between both portfolios. Thus, it captures the fact that managers often try to outperform a benchmark, while maintaining a low tracking error. The M2 measure, owing its name to the authors

Modigliani and Modigliani (1997), also focuses on how to evaluate performance compared to a benchmark. They suggest adjusting the portfolio to have the same risk as the benchmark before comparing them. The M2 is hence equivalent to the return the fund would have achieved if it had had the same risk as the benchmark, often the market index. In essence, it is equal to the Sharpe ratio times the standard deviation of the benchmark. Closely related to the Sharpe ratio is the Treynor (1965) ratio, which divides the expected excess return of a portfolio by its beta, where the beta is calculated on the basis of the CAPM (Sharpe, 1964; Lintner, 1965). The advantage of the Treynor ratio is that it focuses only on the systematic component of risk, not on total risk. Along with the evolution of multi-factor models, such as the Fama and French (1992, 1993) three-factor model, a generalisation of the Treynor ratio has been proposed, including the portfolio's sensitivities to more than one factor (Hübner, 2005).

Although the Sharpe ratio is easy to calculate and in widespread use, it is inappropriate for measuring hedge fund performance, since it assumes normally distributed fund returns—an assumption that rarely bears out. The Sortino ratio (Sortino and Price, 1994) offers a slightly different measure by replacing the standard deviation with the downside deviation. Consequently, the Sortino ratio is more appropriate for hedge funds. Another variant of the Sharpe ratio is the modified Sharpe ratio, also called return over VaR, which has been proposed by Gregoriou and Gueyie (2003). The modified Sharpe ratio replaces the standard deviation in the denominator of the

2. Background



Sharpe ratio with the above-mentioned modified VaR (or Cornish-Fisher VaR). This replacement is motivated by the fact that the MVaR takes the skewness and kurtosis of the return distribution into account.

Other risk-adjusted performance measures. Besides the Sharpe ratio and modificationsthereof, some other risk-adjusted performance measures are explicitly tailored for the non-normal distribution of hedge fund returns. The Stutzer (2000) index tries to capture a behaviourial element of investors, who are assumed to seek to minimise the probability that the return of their investment will be negative over a long time horizon. Since a great likelihood of severe losses increases the likelihood of negative excess returns, the Stutzer index punishes hedge funds with strongly negative skewness and high kurtosis. The Omega ratio has been put forward by Keating and Shadwick (2002). Its advantage is that it also includes its third and fourth moment while requiring no assumption on a fund's return distribution. The Omega is a relative gain-to-loss function using an exogenously (and arbitrary) return threshold. The Omega is then the quotient of the (expected) excess return over a threshold and the expectedloss below the same threshold. Hence, the higher the Omega, the better. In an attempt to create a measure that combines the positive aspects of the Omega ratio (reflecting higher moments) and the Sharpe ratio (easy interpretation), Kazemi et al. (2004) propose a Sharpe-Omega ratio. While identical in terms of ranking to the Omega ratio, it uses the expected excess return in the numerator of the ratio—similar to the Sharpe ratio.

Compared to the previous ratios, the alternative investment risk adjusted performance (AIRAP) measure by Sharma (2004) is an indicator that incorporates an individual risk-aversion parameter when comparing hedge fund performance. Based on a constant relative risk aversion utility function, it also makes it possible to capture the effect of the third and fourth moments of hedge fund returns on an investor's expected utility.

Two conceptually simple ratios to determine return relative to downside risk are the Calmar and Sterling ratios. The Calmar ratio (Young, 1991) is the annual average (expected or past) excess return divided by the maximum drawdown. Again, the aim is to capture downside risk (captured by the maximum drawdown), since some funds provide high returns only by bearing extremely high drawdown risk. Although easily calculated for past returns, the projection of expected returns and drawdowns can be cumbersome. The Sterling ratio (Kestner, 1996) is closely related to the Calmar ratio. It is the ratio of the average annualised excess return to the average maximum drawdown per year over the last three years minus (an arbitrary) 10%.

2.2.4 Beta or correlation analysis: factor modelsAll previous indicators focus on measuring the risk-adjusted performance of hedge fund returns. However, they neglect a crucial part of risk-return considerations: the source of hedge fund returns and their related risks. The aim of beta or correlation analysis is to detect a fund's underlying return drivers by explaining the hedge fund returns through the fund's exposure

2. Background



to various risk factors. Factor analysis is especially important for investors who consider hedge fund investment only as a part of their overall portfolio, such as institutional investors. Pension funds or insurance companies must monitor their overall portfolio risk, not only a hedge fund's specific risks. Fund of hedge fund investors are in the same situation when they make decisions to allocate assets to funds.

Linear factor models. Most factor models used to analyse hedge fund returns are linear models:

(2)

where rt is the monthly return of the hedge fund, α its abnormal performance, βk the sensitivity of the hedge fund to the risk factor k, Fk,t the return of risk factor k, and εt the disturbance term. The primary advantage of linear models is their simplicity: their calculation is straightforward and easy to understand. In addition, since they are commonly used, comparisons of hedge funds are simplified. Most famous factor models try to explain portfolio returns by stock return factors. The most prominent model is the CAPM (Sharpe, 1964; Lintner, 1965), which uses the return of the market portfolio as single factor to account for portfolio returns. Three— and four-factor extensions are by Fama and French (1992, 1993) and Carhart (1997). They include the return spreads between value and growth stocks, small and big stocks, and the differences in the returns of past winners compared to past losers. Another well-known variant of

the linear factor model is the so-called mutual fund style analysis by Sharpe (1988, 1992). This variant accounts for portfolio returns by benchmark returns of different standard asset classes (bills, bonds, equities), thereby attributing the portfolio returns to different investment styles or categories.

Although very popular for traditional investment universes, these linear factor models using standard asset classes as factors tend to have poor explanatory power when it comes to analysing hedge fund returns. The primary reason for this relative impotence is the non-linear and non-normal structure of hedge fund returns (Fung and Hsieh, 2000; Agarwal and Naik, 2000c; Fung and Hsieh, 2001), which cannot be captured by simple equity factor models. Hence, several extensions or adaptations of previous models have been proposed; the aim is to be more suitable for hedge fund factor analysis.

An initial approach, proposed by Fung and Hsieh (1997) is to include in the set of factors the returns of other asset classes, such as commodities (Agarwal and Naik, 2000b; Fung and Hsieh, 2004), exchange rates (Agarwal and Naik, 2000a), or hedge fund indices (Lhabitant, 2001). Also called hedge fund style analysis, these additional factors then capture the nonlinear and dynamic trading strategies as used by hedge funds in the linear factor model. Asecond possibility has been proposed by Agarwal and Naik (2000c), who use equity option portfolios as factors in their model to account for non-linearities.

Non-linear and dynamic factor models. Instead of using factors in the linear

2. Background



model that exhibit non-linear features, an alternative is to model the non-linearity or dynamics in the estimation. Again, there are many ways to model these non-linearities: higher moment adjusted models of the CAPM (Favre and Ranaldo, 2003; Xu et a l . , 2004) , condit iona l regression models (Kat and Miffre, 2002; Kazemi and Schneeweiss, 2006), or regime-switching models (Billio et al., 2007). Finally, truly dynamic models either use Kalman lter techniques to incorporate the dynamic betas of hedge funds (Posthuma and van der Sluis, 2005; Swinkels and Van Der Sluis, 2006) or explicitly model the time-varying structure of a hedge fund's risk exposure (Berk et al., 1999; Zhang, 2004).

Alpha analysis. Alpha analysis is the flip side of beta analysis. In fact, it is simply the intercept of the factor model presented in (2): the residual or abnormal return that cannot be explained by the fund's risk exposure. Accordingly, alpha can be calculated with any of the factor models outlined above— and the value of alpha depends very much on the chosen estimation method. Alpha is basically what investors most prefer, since it reflects (positive) returns without risk.10

2.3 Specific Issues with Hedge Fund Performance

2.3.1 Non-normality of hedge fund returnsUnlike the returns of common stocks and mutual funds, hedge fund returns are generally not normally distributed; see Lhabitant (2004).11 This has considerable

consequences on a number of hedge fund risk measures, as presented in the last sections. Simple measures, such as the Sharpe (1966) ratio, which are based on the normality assumption, are then not valid for assessing the performance and riskiness of a hedge fund. The same applies to all Value-at-Risk measures that assume normally distributed returns.

Non-normality of hedge fund returns is seen easily with statistical tests for normality. The most well-known test is the above-mentioned Jarque-Bera test (Jarque and Bera, 1980). Another popular test is the Lilliefors (1967) test, which is in fact an adaptation of the Kolmogorov- Smirnov test.

As presented in section 2.2, many adjustments of standard risk measures have been proposed to account for the non-normality of hedge fund returns. For example, the Sortino ratio is a good improvement over the Sharpe (1966) ratio, and the Cornish-Fisher VaR a suitable extension of standard Value-at-Risk measures. Hence, it is most important to be aware of a hedge fund's non-normality—the suitable tools to analyse its returns are often straightforward.

2.3.2 Smoothed hedge fund returnsAnother particularity of hedge fund returns is that they are smoother than the returns of mutual funds or common stocks —and, more important, smoother than they ought to be, given their risk exposure. How can this be? Essentially, there are two main reasons for these so-called smooth returns: investment in illiquid assets and deliberate cheating. Since hedge funds often invest in illiquid assets, it is not

2. Background

10 - Since the main purpose of alpha analysis is to calculate risk-adjusted returns, it is often classified as a risk-adjustedperformance measure; see section 2.2.3.11 - Strictly speaking, hedge funds are not log-normally distributed, i.e., their log returns are not normallydistributed. However, often this distinction is notmade. It is also important to mention that the returnsof stocks and mutual funds are not normally distributed either, but the normality assumption is less violatedcompared to hedge fund returns.



always easy to determine the net asset value of the funds. Sometimes, there are no market prices for securities available, and the manager linearly extrapolates the price between two observable prices. Or there might be various quotes for thinly traded securities, so the manager is inclined to use smoothed broker-dealer quotes. The returns thus obtained will usually be much flatter than those of similarly risky but liquid investments. Returns may also be deliberately smoothed by hedge fund managers so their fund will appear less volatile than it is.

Smoothed hedge fund returns and smoothed return data have considerable consequences for the evaluation of hedge funds. Most of all, the funds' volatility does not reflect its true riskiness; it is biased downwards (Asness et al., 2001). As a direct consequence, risk-adjusted performance measures are no longer accurate and might even be meaningless.

In fact, there is empirical evidence that hedge fund returns are too smooth. Getmansky et al. (2004) propose an econometric model of the illiquidity exposure of hedge funds and show that illiquidity is the major reason for the smoothing of hedge fund returns. In contrast, Bollen and Pool (2006) develop a model that makes it possible to detect deliberate cheating in hedge fund returns. They find that for some funds the most likely reason for return smoothing is simply fraud, i.e., the managers misreport return figures to reduce the volatility of the fund's returns, thereby achieving higher Sharpe ratios.

Return smoothing, deliberate or not, can be detected by serial correlation in hedge fund returns. A simple test is the above-mentioned test of autocorrelation by Ljung and Box (1978). In principle, it is also possible to construct risk measures that overcome this problem. Getmansky et al. (2004), for example, propose adjustments to the standard Sharpe ratio that correct for the bias caused by illiquid assets in hedge fund portfolios.

2.3.3 Holdings-based reportingAll the risk measures discussed in section 2.2 share a reliance, in one way or the other, on past return data. Risk-adjusted performance measures relate past returns to past risk exposure; factor analysis explains the sources of past returns by some common risk factors.

In contrast to this so-called return-based risk reporting, holdings-based reporting takes a completely different approach. Holdings-based reporting is in fact a bottom-up approach. It consists of disclosing the exact portfolio composition of a fund, which then allows investors to analyse each of the securities that make up the whole portfolio. The individual risks are then aggregated over the entire fund to obtain the fund's overall risk exposure.

Holdings-based reporting thus has many advantages. First, by definition, it allows a much more detailed analysis of all the risks involved. Second, as a direct consequence, it thereby avoids the estimation errors inherent to return-based reporting. Holdings-based reporting enables investors to choose their own technique for aggregating the risk of different asset or security classes and

2. Background



thus to reflect individual risk preferences. Finally, holdings-based reporting reducesthe problems related to the lack of transparency of hedge funds: since the investor is informed of the exact portfolio composition, the scope for unexpected or even fraudulent behaviour by the hedge fund manager is very limited.

Full portfolio disclosure, however, is counterproductive to good hedge fund performance, since other market participants can easily make use of this information to trade against a hedge fund's strategy. For this reason, holdings-based reporting for hedge funds cannot be too detailed; instead of individual securities, only the holdings of the security classes are made public. In addition, hedge funds publish their portfolio composition with a time-lag, such that the risk profile reflects only earlier positions taken by the fund. Holdings-based reporting also requires substantial data processing, and the investor must have time and the ability to analyse it, as risk analysis is left to the investor. Hence, risk analysis using portfolio holdings requires not only current and past portfolio holdings, but also the exact risk characteristics and risk classication of each of the holdings involved. If not done accurately, it is easy to draw mistaken conclusions. In short, holdings-based reporting is essentially a very good concept. However, for many investors the convenient and rather easy to understand return-based reporting might be more appropriate.

2.3.4 Liquidity risk indicatorsInvestment in illiquid assets not only causes return smoothing, but is also a source of risk on its own. Liquidity

problems can quickly increase the risk of fund failure. Since illiquid positions are very common in hedge funds, liquidity risk is much more of a problem for hedge funds than for mutual funds.

Liquidity and liquidity risk are, unfortunately, not clearly defined. In this section, we describe the two main versions of liquidity risk and liquidity risk measures: asset liquidity risk and funding liquidity risk. Asset liquidity risk is a fund's risk of being unable to sell positions in the portfolio. Funding liquidity risk is the risk of being unable to meet financial obligations when they fall due. Although the two kinds of risk are closely related, the distinction is important. Whereas asset liquidity is much more of an asset management task, funding liquidity has more to do with cash management.12 Asset liquidity risk measures attempt to indicate the liquidity of the assets in the portfolio. The Ljung-Box test (Ljung and Box, 1978) of autocorrelation of hedge fund returns is a practical test for evaluating to what extent the fund contains illiquid assets. Since illiquid assets tend to exhibit relatively constant prices, the returns of a portfolio containing illiquid assets are more likely to be autocorrelated (Getmansky et al., 2004). The percentage of hard-to-value (non-marketable or illiquid) assets is another convenient asset liquidity risk indicator. Average liquidation periods for a specified part of the portfolio are also a good measure of the liquidity risk of a portfolio, although the estimation of such liquidation periods is not straightforward. Hedge funds can also provide estimated impact costs, i.e., the differences between market and realised prices, when unwinding large

2. Background

12 - Note that both kinds of liquidity risk refer to risks in hedge funds. In addition to these risks, investorsusually face an additional liquidity risk due to the lock-up periods, as mentioned in section 2.2.2.



investments. Finally, similar to extreme performance risks, stress tests can help to analyse the impact of critical market situations on a portfolio's liquidity.

Funding liability risk indicators try to capture the provision of cash to meet obligations. Liquidity ratios, such as cash-to-equity or VaR-to-cash ratios, are a simple class of funding liquidity risk measures. Asset-liability match analysis attempts to examine the timing of portfolio transactions. By relating future payments and redemptions to each other, this analysis helps to detect possible mismatches and thus liquidity constraints well in advance. Similarly to asset liquidity, hedge funds can simulate funding liquidity stress tests to evaluate the impact of adverse market conditions on the cash situation of the fund.

2.3.5 Leverage risk indicatorsUnlike mutual funds, hedge funds can make use of financial leverage by borrowing large amounts of capital. Although leverage is not a source of risk on its own, it usually amplifies all other risks. Especially great is the impact of leverage on liquidity risk. It is important to note that leverage is not bad in itself, as it is a convenient means of shifting a portfolio towards the desired risk-return profile. But there is no universal leverage risk indicator, since the usefulness of the indicator depends very much on the hedge fund strategy. A good overview of leverage indicators is found in Rahl (2003).

Leverage risk indicators can be classified in two main groups: accounting and risk based leverage measures. Accounting-based leverage indicators are usually

simple ratios of information found in a hedge fund's financial statement. These measures, such as gross assets-to-equity, debt-to-equity, or their inverses allow an initial assessment of a fund's leverage. The problem with these ratios is that they do not capture off-balance sheet leverage. For example, futures can imply high leverage but may not appear in the financial statements. Neglecting this exposure can be misleading. For this reason, Breuer (2000) suggests incorporating off-balance sheet leverage exposure in the ratios (such as that represented by futures) by calculating their balance sheet equivalent.

Risk-based measures are another possible means of capturing off-balance sheet leverage. The aim of these measures is to capture the leverage of a fund by relating its risk exposure to a balance sheet component, again, usually net asset value of equity. Some of the prominent ratios are VaR-to-equity, volatility-to-equity, or stress loss-to-equity. Here, off-balance sheet leverage risk is automatically included via the risk component in the numerator. McGuire et al. (2005) propose another risk-based leverage measure using hedge fund style analysis. They observe that the coefficients of the factors in style analysis should add up to one if no leverage is used. This observation led the authors to the conclusion that the sum of the coefficients is a very useful leverage indicator, since any deviation from one is a clear sign of using leverage, both on and off balance sheet. For example, a sum of beta coefficients of two indicates a portfolio risk exposure twice as large as the investors' capital, and hence leverage of 100%.

2. Background



2.3.6 Operational risk disclosureAlthough often neglected as an independent source of risk, operational risk is perhaps the greatest risk for hedge fund investors. As Giraud (2005) shows, half of all hedge fund failures are caused by operational risk problems, such as misrepresentation of a fund's net asset value, fraud, or trading activities outside of the fund's mandate. That this risk is the cause of so many failures underscores the need for disclosure. It is clear that no investor can expect to be fully insured against fraud by hedge fund management, but detailed operational risk disclosure can reduce its impact significantly. We describe below the basic ingredients of operational risk disclosure. Since risk related to a fund's valuation framework accounts for the lion's share of operational risk disclosure, it is presented in a separate paragraph.

First, each hedge fund should issue a private placement memorandum (PPM) that provides an overview of the hedge fund's strategy, including its investment style, the asset classes it uses and its geographic exposure, and the planned use of leverage. It also includes a detailed description of the organisation of the fund: the legal framework, information on proxy voting, redemption rights, or fee structure of the fund should be stated clearly. Next, the hedge fund should provide as much information as possible on the hedge fund management itself, e.g., the vitae of the managers and the possible conflicts of interests of the management team. In addition to the problems relating to fee incentives (see section 2.1.1.), such internal conflicts can arise when managers run different hedge funds, so

they could be inclined to manage the fund's allocation to optimise their joint fee income. Conflicts of interest can also occur between hedge fund investors, such as those induced by side letters and parallel-managed accounts for some specific investors. Hence, any fund should disclose the existence of such arrangements. Another source of operational risk is the involvement of third parties. The hedge fund team should consequently disclose the main counterparties of the hedge fund and provide a short analysis of the risks involved in outsourcing activities to partners. Finally, hedge funds should arrange for special event reporting, i.e., an irregular disclosure of important information on the occasion of significant market or strategy changes.

Valuation frameworkThe most important part of operational risk disclosure is, by far, the valuation framework. Since hedge funds invest in many different and complex financial products, some of which are not regularly traded, the calculation of its net asset value is not simple. Often there are many ways to calculate the current value of a specific asset, and all yield different results. Moreover, it is not always obvious which valuation technique—and thus which valuation—is most appropriate. For this reason, a clear statement of a fund's valuation principles is indispensable. We summarise below the main valuation principles used by hedge funds.

For liquid assets, market prices are in general the best source of an asset's value. However, prices can be either ask, bid, or mid-prices, and they can be calculated as an average over a certain

2. Background



time period. Obtaining a value for illiquid assets is much more difficult. One possibility is to use pricing models: derivatives are best priced with stochastic pricing models. Loans or private equity investments might be valued with the help of discounted cash flow models. If related financial instruments are traded in the market, arbitrage pricing models are useful. Finally, counterpart quotes or estimates are another source of an asset's value. It is sometimes possible to assign the valuation of difficult and complex assets to third parties.

It is also important to have clear control mechanisms that ensure that the valuation principles are respected at all times. An initial mechanism is to assign the determination of the fund's net asset value to a third party valuation service provider or administrator. If the valuation is done in-house, it is possible to ensure compliance with the valuation framework by strictly separating the duties of the manager and administrator, who is in charge of the valuation. Finally, hedge fund managers might opt to do the valuation themselves, but have valuation policy validated by an external auditor.

2. Background

3. Methodology and Data




3.1 Methodology The EDHEC Hedge Fund Reporting Survey was taken with an online questionnaire and electronic mail to European professionals in the hedge fund industry. To capture the conflicting views and opinions on hedge fund reporting, this survey targets three groups of professionals. First, and quite evidently, this questionnaire was addressed to hedge fund managers, since they ultimately decide how their funds will report. Next, and in counterpoint, this survey invited hedge fund investors to respond. Since hedge fund investors are a heterogeneous group, it was our aim to target a broad mix of institutional and private investors. The third group of survey participants, finally, is made up of fund of hedge fund managers. This professional group is perhaps the most interesting, since it is acive on both sides of the hedge fund industry. Funds of hedge funds are investors and fund managers at the same time, and their views can thus provide comprehensive insights into hedge fund reporting.

The questionnaire consisted of three sections with roughly twenty-five multiple choice questions each. In a first series of questions, the survey participants are asked for their general view on the importance of and their satisfaction with current hedge fund reporting. The next set of questions turns to the central issue of this survey: appropriate performance measures and performance risk indicators. In the last set of questions, the questionnaire asks participants for their view on such issues of hedge fund reporting, as liquidity risk and leverage risk reporting, or on the disclosure of

operational risk in hedge fund reports. Finally, survey participants were given the possibility to add further comments on the general issue of hedge fund reporting.

3.2 DataThe survey was taken in the summer of 2008. The first response was received on July 4, 2008, the last on October 1, 2008. Nearly 90% of the 214 respondents to the survey are based in Europe, many of them in the UK, Switzerland, and France. The exact breakdown is shown in exhibit 1.

Exhibit 1: Country of survey participants

35.5%

4.7%

17.8%

10.3%

17.8%

4.7%

9.3%

United KingdomSwitzerlandItalynon EU

FranceGermanyother EU

Exhibit 2: Profession of survey participants

38.3%

30.4%

31.3%

Fund of hedge fund managementHedge fund managementInvestor





Next, as can be seen in exhibit 2, all three target groups of this survey, i.e., fund managers, fund of hedge fund managers, and investors, are almost equally represented. Some two-thirds of the investors are institutional investors (pension funds, insurance companies). The remainder are either private bankers or private investors. The respondents occupy high-ranking positions: 20% are CEOs, and more than half have such positions as CIO, CFO, or head of risk management (see exhibit 3).

Exhibit 3: Function of survey participants

20.1%

19.2%

10.7%

18.2%

10.7%

9.8%

4.7%

6.5%

CEO/Managing DirectorHead of Risk ManagementHead of Asset AllocationAssociate/AnalystCIO/CFOHead of Reporting ServicesPortfolio/Fund ManagerMarketing Position

Finally, exhibit 4 shows the assets under management of the companies for which the survey respondents work. As was to be expected, there are a few very large firms in the hedge fund industry that have more than 100bn EUR in assets under management. However, our survey mainly reflects the views of medium-sized companies, with assets under management of between 100mn and 10bn EUR. We also capture the opinions of small firms, with

20% having assets under management of less 100mn EUR. This regional diversity and the fair balance of the hedge fund professionals make the survey largely representative of the European hedge fund industry.

Exhibit 4: Assets under management (EUR)

4. The View of the European Hedge Fund Industry on

Current Disclosure Practices




In this section, we present the survey results. In principle, we follow the structure of the previous background chapter so that for each topic interested readers can easily find the corresponding detailed explanation in section 2. First, in section 4.1, we take a general look at theindustry's perception of hedge fund reporting, its importance, objectives, and the industry's most important information sources for good hedge fund disclosure. In section 4.2, we turn to the the key indicators of hedge fund performance and risk. Finally, section 4.3 examines specific risks hedge funds are generally exposed to, such as liquidity, leverage, and operational risk.13

4.1 Hedge Fund Reporting: the Big Picture

4.1.1 Hedge fund reporting as quality signalFirst, we look into the overall importance of hedge fund reporting. The result is clear: over 90% of all participants indicate that the reporting quality of a hedge fund is an important signal for the fund's overall quality (see exhibit 5). Put differently, investment decisions can hinge on reporting quality: if it is not sufficient, many investors are likely to hold back investment. We will return to this issue in subsection 4.1.5.

Exhibit 5: Is hedge fund reporting an important signal for a hedge fund's overall quality?

4.1.2 Objectives of hedge fund reportingWe then examine what industry practitioners view as the main objectives of hedge fund reporting. Exhibit 6 shows the results. Most practitioners (61%) think that the main objective of hedge fund reporting is to assess the risk/return profile of the hedge fund under consideration. Risk information for the investors' total asset allocation (47%) and performance attribution (45%) are also viewed as important objectives of hedge fund reporting. These findings stand in contrast to other cited objectives of hedge fund reporting: only 17% perceive reporting as a means of advertising the funds' quality and 12% see hedge fund disclosure as a way for investors to ensure that regulatory scrutiny will turn up nothing untoward.

Exhibit 6: Objectives of hedge fund reporting

4. The View of the European Hedge Fund Industry on Current Disclosure Practices

13 - Note that in the following—if not otherwise stated—fund of hedge fund managers are sometimes considered investors, other times fund managers, depending on the question.




Although those in the industry largely agree on the objectives of hedge fund reporting, they diverge remarkably in some aspects. For example, whereas fund of hedge fund managers consider reporting a major means of controlling managers' behaviour (46%), hedge fund managers themselves regard this aspect of reporting as rather unimportant (15%). In contrast, these fund managers consider reporting a useful fund selection device (51%) and a means of advertising their products (26%). Investors, by contrast, find that advertising is a negligible component of hedge fund disclosure (7%).

4.1.3 Components of good hedge fund reportingAgainst the backdrop of the survey respondents' views of the main objectives of hedge fund reporting, we analyse what they believe to be the keys to achieving these objectives. The answers are shown in exhibit 7. Most of all, hedge fund reporting should be consistent, clear, and timely. Information on the fund's absolute risk is considered most important. In contrast, high frequency is not required to achieve the objectives of hedge fund reporting as reported by survey respondents Surprisingly, information about operational risk is considered largely unimportant. The same holds true for the qualitative outlook on the hedge fund's strategy.

Exhibit 8 shows the important components of hedge fund disclosure by professional group. It shows that hedge fund managers and investors have diverging views on what constitutes solid reporting. In general, investors tend to require more information than hedge fund managers deem

important. Fund of hedge fund managers often take the middle way. Agreement is highest on the necessity of the consistency and clarity of hedge fund reporting. But investors would like to see much more disclosure on liquidity risk, operational risk, and the portfolio composition of hedge funds than fund managers consider necessary. This observation shows that operational risk is considered unimportant only by fund managers.

Exhibit 7: What is important for a good hedge fund report?

Exhibit 8; What is important for a good hedge fund report?Anwers by professional group

4.1.4 Satisfaction with current hedge fund reportingAfter having created the frame for the industry participants' view of important elements of hedge fund reporting, we now turn to the investors' satisfaction with current reporting practices. Exhibit 9 shows the satisfaction with the facets of hedge fund reporting as identified by both fund of hedge fund managers and



investors. Investors are satisfied with the consistency, clarity, and frequency of their hedge funds' disclosure. Information on past returns also appears satisfactory. However, investors express concerns about the quality of the disclosure on liquidity and operational risks. In general, both groups of hedge fund investors have a similar view on hedge fund disclosure quality, although end investors tend to be less content.

Exhibit 9: Satisfaction with hedge fund reportingAnswers by professional group

Exhibit 10 takes another look at investors' satisfaction by opposing perceived importance with the perceived quality of the aspects of hedge fund reporting. The scatter plot thus makes it possible to identify aspects of hedge fund reporting that are judged very important, but for which standards are not yet met (upper left part of the plot). Not surprisingly, disclosure on liquidity risks exhibits the worst quality-to-importance ratio, followed by operational risk reporting. Frequency of reporting and information on past returns have the highest such ratio.

Exhibit 10: Hedge fund reporting—wishes and realityAnswers by fund of hedge fund managers and investors

4.1.5 Information sources for hedge fund reporting standardsFinally, we examine the information sources that are most influential for the industry's opinion of optimal hedge fund disclosure. Exhibit 11 shows that so-called "best practices" and industry guidelines by government working groups or industry associations have the greatest impact on the industry (63% of the respondents). Next important is the opinion and practices of industry peers. Academics, consultancies and public opinion have little impact on the industry's view of hedge fund disclosure.

Exhibit 11: Information sources for good hedge fund reporting

Many of the hedge fund managers and investors have internal disclosure guidelines as well. In fact, between 70 and 80% of investors have internal disclosure standards that must be met before they




actually invest in a hedge fund, as can be seen on the right side of exhibit 12. This again underscores the importance of hedge fund reporting. Over 60% of the the hedge funds have clear guidelines for information they disclose to their investors.

Exhibit 12: Existence of internal disclosure rulesAnswers by professional group

4.2 Key Indicators: Performance Indicators and Risk MeasuresIn this subsection, we take a closer look at the key performance indicators and risk measures used in hedge fund reporting. Essentially, all indicators can be classified into one of four groups: return analysis, extreme risk measures, risk-adjusted

performance analysis, and correlation (or beta) tests. First, we ask all industry practitioners to rank these four elements of performance and risk analysis by order of importance. The results, as shown in exhibit 13, reveal major differences in the relative importance of these key indicators. Hedge fund managers believe in the importance of risk-adjusted performance measures, whereas investors and fund of hedge fund managers consider them the least important. These two professional groups report that return analysis and extreme risk measures are the most important means of evaluating a hedge fund's performance. However, there is some agreement that correlation or beta analysis is a rather unimportant part of overall hedge fund performance disclosure.

Exhibit 13: What risk measures are important for a good hedge fund report? Answers by professional group

4.2.1 Return analysisOur first look is at the descriptive statistics and statistical tests of hedge fund returns that are considered essential for the return analysis. The results are displayed in exhibit 14. The survey shows that both investors and hedge fund managers have a clear preference for simple but informative return indicators. Maximum past drawdown, an easy indicator of a fund's downside risk, is regarded as the most important indicator obtained from past returns. Other indicators




about downside risk deemed important are the fund's returns during extremely negative equity markets and the lower partial moments of hedge fund returns. Besides downside risk, practitioners also view information on the fund's volatility and return persistence as crucial. More rigorous and sophisticated statistical measures and tests, such as the skewness and kurtosis of hedge fund returns, or tests of their normality appear not to be of particular interest to the hedge fund community.

Exhibit 14: Important elements of return analysis of hedge funds - Answers by professional group

4.2.2 Extreme risk indicatorsNext, we turn to the industry's opinion of extreme risk indicators. The results are striking: more than two-thirds of respondents believe that stress tests are the most important means of assessing a hedge fund's extreme risk exposure (see exhibit 15). This overwhelming approval of stress tests is found industry-wide; investors and hedge fund managers agree on their importance. This nearly unanimous embrace of stress tests is surprising, as they come with two major drawbacks. First, they are opaque: the assumptions behind the stress tests are not always obvious, and they can differ substantially from one fund to another. Put differently, they are highly subjective (Jorion, 2001).

Second, one can stress-test only the impact of problems that are potentially known in advance. But it is problems that cannot be foreseen that are the real test of a fund's risk management.

Exhibit 15: Important extreme risk measures for good hedge fund reporting

Value-at-Risk is also very important to the hedge fund industry. That advanced Value-at-Risk models, such as those based on non-normal Monte Carlo simulations, are seen as superior to simple parametric implementations is very encouraging. Conditional VaR, closely related to VaR, is also very popular in the industry.

Given the relative importance of Value-at-Risk measures, we also attempt to determine whether investors and fund of hedge fund managers are aware of the models used to calculate Value-at-Risk as it appears in hedge fund reporting. It turns out that more than 40% of all final hedge fund investors indicate that they do not know how the Value-at-Risk information is calculated (exhibit 16). Since the information value of VaR depends very much on the chosen model, not publishing their assumptions is unacceptable. Fund of hedge fund managers seem to be somewhat better informed, with only 20% unaware of how VaR is calculated.




Exhibit 16: Do your hedge funds indicate how they calculatedVaR? - Answers by professional group

4.2.3 Risk-adjusted returnsExhibit 17 shows the most important risk-adjusted return indicators, as perceived by the industry. The exhibit shows that more than 67% of all respondents—regardless of their profession—consider the Sharpe ratio the best means of measuring a fund's risk-adjusted return. Although this popular ratio has the advantage of being easy to calculate, it is not appropriate for evaluating hedge funds, since it is based on the (mistaken) assumption that returns are normally distributed. It it therefore encouraging that the Sortino ratio, which is more suitable for hedge funds, comes next for assessing hedge fund returns (55%). Other important measures include the information ratio, the Omega ratio, and the modified Sharpe ratio. Given the multitude of indicators, it is not surprising that many are not widely used. Moreover, many of the indicators, such as the Calmar and Sterling ratios, are interchangeable.

Exhibit 17: Importance of risk-adjusted performance measures for good hedge fund reporting

4.2.4 Beta analysisThe fourth component of a hedge fund's risk and performance analysis is correlation or beta analysis, i.e., the explanation of hedge fund returns by their systematic risk exposure with the help of factor models. First, survey participants are asked for their opinion on both linear and non-linear factor models. The results are shown in exhibit 18. The graph emphasises that beta analysis using factor models is considered important, with non-linear models slightly preferred. This finding underscores that industry participants are well aware of the shortcomings of simplelinear approaches to modelling hedge fund returns. The exhibit also shows that investors are much more convinced of the usefulness of this approach than are managers, especially hedge fund managers.

Exhibit 18: Importance of factor modelsAnwers by professional group




Against this backdrop, we turn to hedge fund managers and look into whether they actually disclose their fund's factor exposure to investors. For investors, the answers are disappointing. Only some 15% of all hedge funds disclose this important information (exhibit 19)—an unacceptably low percentage. We also find that many hedge funds believe that investors are uninterested in the beta exposure, or that they restrict information disclosure to keep reports concise (see exhibit 20).

These practices, however, are at odds with their investors' perceptions, as seen in exhibit 18. So, hedge fund managers are either unaware of their clients' true needs for information or unwilling to state their reasons for failing to disclose their fund's factor exposure. They may be afraid of publishing their strategic or tactical exposure, as acknowledged by a substantial fraction of the managers responding to our survey.

Exhibit 19: Do you publish the factor exposure of your hedge fund? Answers by professional group

Exhibit 20: Why don't you disclose these additional measures? Answers by professional group

Finally, we take a look at those managers who report beta analysis to investors. Although these investors are in a better position than their uninformed peers, many receive information on factor exposure using only simple, non-linear models (see exhibit 21). As argued above, such models are far from appropriate for modelling hedge fund returns, so the information obtained is insufficient. All the same, the reporting of beta exposure is likely to remain a controversial issue for the hedge fund industry.

Exhibit 21: Which factor models do you use?Answers of all respondents that publish factor exposure

77.8%22.2%

Linear factor modelsNon-linear factor models

4.2.5 Alpha analysisAlpha is simply the intercept of the factor models used to calculate the beta exposure in the previous section—and thus theoretically redundant. However,




given its widespread interpretation as risk-adjusted or abnormal return, it is often included in hedge fund reports and treated separately. Exhibit 22 shows the industry's opinion of the use of alpha in hedge fund reporting. The result is clear. Regardless of the professional group, alpha analysis is considered very important—and appears to be more important than the factor analysis itself. We then ask which methods should be used to calculate a fund's alpha. The answers are striking. The most frequently mentioned technique for calculating alpha is the hedge fund's return difference compared to a peer group (see exhibit 23). In a similar vein, many respondents also report that the return difference to a hedge fund index would be appropriate for estimating alpha. Only about half of the respondents argue that factor models—either linear or non-linear—should be used to estimate alpha.

Alpha analysis can be used in two different ways. It can be regarded as a measure to compare the performance of a fund to a benchmark, or it can be considered an indicator of abnormal returns, i.e., returns that cannot be attributed to a fund's risk exposure. In either case, however, peer group comparisons and return differences to hedge fund indices are inappropriate, since they do not reflect all the risks of investing in hedge funds.

Exhibit 22: Is alpha analysis important?Answers by professional group

Exhibit 23: Which methods should be used to calculate alpha?Answers by professional group

4.2.6 Disclosure of performance measuresTo conclude this section on risk and performances indicators, we ask whether hedge fund and fund of hedge fund managers calculate any risk and performance measures that they use internally without disclosing to investors. As it happens, a large majority (over 60%) of hedge fund managers use more performance indicators than they publish (see exhibit 24).




Exhibit 24: Do you use additional performance measures for internal use only? Answers by professional group

Interestingly, more than 20% of the hedge fund managers taking our survey do not answer this question. This raises the question of why fund managers hold back potentially important information that they consider relevant for themselves. As exhibit 25 shows, the main motivation for their failure to disclose these additional performance and risk measures is that they believe investors are uninterested in these indicators.

Exhibit 25: Why don't you disclose these additional measures? Answers by professional group

Why not let the investors decide which information is important? Perhaps to keep reporting concise, as about 50% of the respondents argue. Only 20% of all fund of fund managers and 40% of all hedge fund managers state that reporting additional figures would mean too much disclosure of their investment strategy.

4.3 Specific Hedge Fund Risks ReconsideredIn the final set of questions, we examine practitioners' views of risks and issues of particular importance to the hedge fund industry.

4.3.1 Non-normality of hedge fund returnsAs presented in section 2.3.1, it is widely accepted that hedge fund returns are not normally distributed. Non-normality can have considerable consequences on the risk and performance evaluation of hedge funds, since standard measures are based on the assumption of normality, and are thus unsuitable for hedge funds (see sections 2.2.2 and 2.2.3 for more discussion).

Exhibit 26: Non-normality is an important issue for measuring hedge fund performance. Answers by professional group

Exhibit 26 indicates that most industry professionals, largely regardless of their exact professional role, agree that non-normality is an important issue forthe hedge fund industry. However, the respondents' knowledge of this issue seems to come to an end at this point.

As exhibit 27 shows, more than 60% of those responding to the survey do not know how to measure non-normality. Only about 30% of the respondents have a view on appropriate tests. The remaining 10% argue that no test is needed, perhaps a valid viewpoint, given the abundant




empirical evidence for non-normality of hedge fund returns. To conclude, there is a significant gap between theory and practice: evidence shows that the industry is well aware of non-normality, but does not always draw the right conclusions; after all, the Sharpe ratio is still preferred for measuring risk-adjusted returns (see exhibit 17).

Exhibit 27: What test should be used to detect non-normality of hedge fund returns

4.3.2 Smoothing of hedge fund returns

Exhibit 28: Return smoothing is a significant issue for measuring hedge fund performance

The smoothing of hedge fund returns is another delicate issue investors commonly face, as discussed in section 2.3.2. As exhibit 28 shows, more than 70% fully or largely agree with the statement that return smoothing is a significant issue for measuring hedge fund performance risk. When asked what they consider the main reasons for the smooth returns of

hedge funds, most practitioners indicate the linear extrapolation of illiquid asset prices (exhibit 29). Another 23% argue that weighting of different asset prices available at the same time is a major reason for smooth returns. Surprisingly, almost 30% are convinced that smooth returns are a clear sign that hedge fund managers deliberately modify the prices in the direction they want, i.e., that they use the illiquid assets to manipulate their fund's returns. Most interesting is the observation that this percentage is equally high industry-wide. Put differently, hedge fund managers are no less likely than their investors to say that they themselves—or their less scrupulous colleges—misstate the prices of some assets to achieve smoother (i.e., less volatile) returns.

Exhibit 29: Reasons for return smoothing

We then turn to possible solutions to the problem of smoothed returns, the so-called smoothing-robust performance measures. However many industry participants appear not to be convinced by the usefulness of these measures. Most respondents argue that these measures are very complicated (52%) or express concerns that even these sophisticated measures could be manipulated (55%). Again, there are no significant differences from one industry profession to another.Exhibit 30 shows that smoothing-robust measures are rarely used. Less than 5% of




the fund managers state that they disclose performance based on these measures, and less than 20% of the investors receive such measures from their funds.14 This low proportion might reflect the industry's critical view of such indicators. That up to 30% of investors do not even know whether they receive such information is perhaps an indication that many survey respondents are unaware of the existence of robust measures.

Exhibit 30: Do you publish or receive return-smoothing robust performance measures? Answers by professional group

4.3.3 Holdings-based reportingWe seize the opportunity of this survey to ask practitioners what they perceive to be the pros and cons of holdings-based reporting, a possible solution to at least some of the problems of hedge fund

reporting, as argued in section 2.3.3. The results are shown in exhibits 31 and 32.

Exhibit 31: Advantages of holdings-based reporting

Exhibit 32: Challenges of holdings-based reporting

Respondents report that the main advantage of holdings-based reporting is that it affords the possibility to carry out a very detailed risk analysis (75%); it has the advantage of letting an investor choose his own techniques to analyse a fund's riskiness (56%) and of transparency greater than that of return-based reporting (51%). By contrast, nearly half of respondents argue that holdings-based reporting requires a lot of know-how and means substantial data analysis (both 48%). Other disadvantages mentioned are the time lag with which investors receive the information (41%) and the observation that holdings based reporting works only with very detailed information (34%). The answers are broadly similar across all hedge fund professions.


14 - The proportion of investors that receive robust performance information (20%) should be more or less equal to the percentage of funds that disclose such information (5%). The divergence can be explained by either a mismatch of the samples (investor respondents are investing preponderantly in funds that are disclosing more information than those of our sample) or by badly informed investors (they consider the returns they gotrobust, whereas in fact they are not).



If asked to express a preference for one of the two reporting styles, half of the practitioners would prefer holdings-based reporting and the other half would opt for return-based reporting (see exhibit 33). Yet there are significant differences between the professional groups. Investors have no clear preference, hedge fund managers prefer return-based reporting, and fund of fund managers would choose holdings-based reporting. This finding is quite intuitive: since hedge fund managers might fear that too much valuable detail about their investment strategy would be revealed to the public, they favour return-based reporting. In contrast, fund of hedge fund managers, who are probably the most sophisticated class of investors, are much more positive about holdings-based reporting, since they might be more competent in dealing with this reporting style than end investors.

Exhibit 33: If you had to choose between holdings and return based reporting, which reporting style would you prefer?Answers by professional group

Again, we investigate how commonly used holdings-based reporting actually is. Exhibit 34 shows that about one-third of hedge funds offer this service to their investors, whereas 50% do not. This corresponds to the investors' declaration that about 43% of them actually receive holdings-based information. Finally, 47% of those who receive this information from their hedge fund managers report

that they are satisfied with it; 22% report that they are not (not shown).

Exhibit 34: Do you offer holdings-based reporting to your clients?

4.3.4 Liquidity riskNext, we turn to risks that are of particular importance to hedge funds. First, we examine the industry's view of the relevance of the liquidity risks to their business (see exhibit 35).

Exhibit 35: Is liquidity risk an important source of risk for hedge funds? Answers by professional group

The answer is unequivocal: liquidity risk is considered a major source of risk for hedge funds, especially for hedge fund investors, more than 80% of whom classify this source of risk as "very important". Yet this clear view contrasts sharply with the industry's satisfaction with the current coverage of liquidity risk in hedge fund disclosure. Some 80% of all respondents state that liquidity risk is not sufficiently captured in hedge fund reporting (exhibit 36).




Exhibit 36: Is liquidity risk well captured by current hedge fund reports? Answers by professional group

Amazingly, there is no difference across the three professional groups; even hedge fund managers admit the poor information disclosure on hedge fund liquidity risks. So why is liquidity risk reporting so bad? As exhibit 37 shows, many industry participants believe that liquidity risk is hard to define (30%), that existing liquidity measures are not good enough (27%), or that they do not capture all the facets of liquidity risk (38%). Most of all, however, practitioners believe that liquidity risk is simply neglected in current hedge fund disclosure practices (55%).

Exhibit 37: What are the problems of liquidity risk reporting?Answers by professional group

Exhibit 38: Important liquidity risk indicators

As far as liquidity risk measures are concerned, most practitioners value information on average liquidation periods highly (as exhibit 38 shows, more than 67% consider this indicator one of the most important liquidity risk indicators). Information on the percentage of hard-to-value assets of the portfolio is also perceived to be important. Statistical tests such as the Ljung-Box test play only a minor role for the industry.

4.3.5 Leverage riskAs exhibit 39 shows, our survey participants also agree that leverage risk is also a major risk component for hedge fund investment strategies: more than 96% state that leverage risk is an important or a very important source of risk for hedge funds, and is thus judged equally decisive as liquidity risk.

Exhibit 39: Is leverage risk an important source of risk for hedge funds?

However, risks related to leverage appear to be better reflected in current hedge fund reports than are liquidity risks. Exhibit 40 indicates that between 31 and 39% of industry participants consider that leverage risk is well captured by current hedge fund reports. Even so, 54% of all end investors are dissatisfied with leverage risk reporting; only 30% of hedge fund managers report similar dissatisfaction—again a sign that investors overestimate the quality of their reporting.




Exhibit 40: Is leverage risk well captured by current hedge fund reports? Answers by professional group

Ratios that include off-balance sheet leverage, such as contained in futures, are considered the most important leverage risk indicators (exhibit 41). These ratios are definitely much better indicators than the simple balance sheet ratios, as argued in section 2.3.5. Risk-based leverage measures, such as VaR-to-equity are also popular—and sensible indicators as well.

Exhibit 41: Important leverage risk indicators. Answers by professional group

4.3.6 Operational risksFinally, we examine the practitioners' perception of one of the most intangible risks for hedge funds, operational risk. Since it is even more difficult to comprehend than risk related to a fund's liquidity, we attempt to identify industry views of the most important elements of operational risk reporting. As exhibit 42 shows, it is issues related to the pricing and the valuation of hedge funds (identified by more than 76%) that the industry views as the most crucial elements of operational

risk reporting. Information on internal risk management and internal controls are also seen as major aspects of operational risk reporting. As with the analysis of other risks, we then ask those surveyed whether the information provided on operational risk is sufficient or meets their demands (as investors). The answers, shown in exhibit 43, reveal that exactly those aspects that are considered most important are those that are considered most wanting; that is, information on a fund's valuation framework and on the internal controls a fund puts in place. Moreover, as is to be expected, hedge funds rate their information disclosure more highly than do fund of hedge fund managers and investors. Very clearly, these two key elements of hedge fund reporting require substantial improvement.

Exhibit 42: Important aspects of operational risk reporting

Exhibit 43: Does hedge fund reporting provide investors with sufficient information on…? Answers by group




Given the perceived importance of information on pricing and valuation and its unsatisfactory disclosure, we investigate these issues in more detail. One crucial aspect of a hedge fund's valuation is the treatment of hard-to-value assets. In exhibit 44 we show the industry's views on how to mitigate the risks of hard-to - value instruments.

Exhibit 44: What is your preferred approach to mitigating the risks of hard-to-value instruments?

The overwhelming majority of respondents report that information provided by different brokers is the best means of pricing illiquid or hard-to-value assets. Although this procedure is objective and has intuitive appeal, it will translate into overly smooth total hedge fund returns, as shown in section 2.3.2. Estimates provided by the managers are considered the second best way to obtain a price for difficult-to-price assets. Manager estimates, however, are a double-edged sword. Hedge fund managers ought to know the assets they hold and related asset markets better than many other market participants, suggesting that theymight naturally be in a better position than anyone else to price these assets, but if the manager prices the instruments he holds on his own, no pricing controls are possible, even if the overall fund valuation is verified by an independent third party. Thus, this method might be used to

manipulate a fund's total value—clearly not in the interest of the investors. Hence, manager estimates should be a last resort, if there is no other means of obtaining reliable prices.

Finally, we seek the industry's opinion of the best valuation procedures or mechanisms to ensure coherent hedge fund valuation. Most survey respondents (80%) favour external valuation of the fund's net asset value by independent platforms or administrators to ensure a consistent pricing policy (see exhibit 45). About 62% of respondents believe that the disclosure of the proportion of mark-to-market vs. mark-to-model pricing of the overall fund is a very useful means of ensuring consistent pricing. Although this ratio can obviously provide valuable information on the fund's sensitivity to partially subjective model pricing, it cannot be regarded as a means of ensuring a that a fund complies with its pricing framework. Finally, only 25% believe that in-house validation with separation of duties or external auditing is an appropriate means of ensuring consistent valuation.

Exhibit 45: Which of the following control mechanisms should be imposed to ensure coherent valuation?


Conclusion




This study presents the results of a comprehensive survey of hedge fund professionals; it sheds light on their perception of current hedge fund reporting practices. In analysing the industry's spectrum of opinions, we identify critical points of conflict in the alternative investment business. First, we find that the quality of hedge fund reporting is perceived to be an important indicator of a fund's overall quality and a crucial investment criterion. However, investors consider the overall disclosure insufficient. Investors are especially dissatisfied with the quality of information on liquidity and operational risk exposure. Finally, this study also shows that inappropriate performance measures prevail in the hedge fund industry. Although empirical studies present evidence that the Sharpe ratio, for example, is not suitable for reporting risk-adjusted hedge fund returns, many respondents still rely on this measure.

The results of this survey have a number of important implications for the hedge fund industry. First, great differences between hedge fund managers' perceptions of relevant information disclosure and their investor's needs suggest that the industry should rethink its overall disclosure practices. Hedge fund managers should take their investors' demands for more information seriously and improve disclosure on liquidity risks, leverage risks, portfolio composition, and valuation frameworks. In principle, hedge fund managers should be ready to provide such information, since they already agree—in many cases—with their investors' view that hedge fund reporting is insufficient. Although there might be sensible reasons not to disclose the portfolio composition

of hedge funds in too much detail, other aspects of risk reporting could be easily improved without endangering a hedge fund's investment strategy. Second, hedge funds and funds of funds should move to more appropriate risk and performance measures when disclosing their returns to investors. A large body of academic literature shows that many prevailing risk measures are not up to the task of reporting the true economic risks of investing in hedge funds. The problem is not that there are no meaningful indicators, but that they are not actually used. In this context, it might be useful to make both hedge fund managers and investors more aware of the specific risks of their industry.

Finally, the evidence on hedge fund reporting practices suggests that current guidelines and "best practices" of industry associations and government working groups are insufficient to enhance hedge fund transparency and thus investor confidence. Although these guidelines have a highly positive impact on the hedge fund industry, they rarely provide guidance on sound hedge fund disclosure. If they do so at all, they are very vague and predominantly cover topics where there are already information disclosure standards, such as those that call for consistent, clear and timely reporting of past returns. Hence, these best practices fall short of encouraging hedge funds to provide information on very important aspects of hedge fund risks. Guidance on disclosure of a fund's risk-adjusted returns, extreme risks, leverage and liquidity risk, or its factor exposure is especially wanting. To ensure greater hedge fund transparency, existing guidelines should be extended to cover these risks as well. It is important

Conclusion



to note that this statement should not be misinterpreted as a call for greater regulation of the hedge fund industry. All the same, better reporting practices are likely to be beneficial to all in the industry.

Improving the quality of hedge fund reporting lies at the heart of creating a more transparent industry environment. Better hedge fund transparency is likely to have many advantages. First, it will lead to increased investor participation and less capital flight during financial crises. Second, better informed investors will contribute to greater discipline on the part of hedge fund providers. Finally, a better marketplace for hedge funds is likely to make a positive impact on market efficiency and financial innovation.

Conclusion

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The choice of asset allocationThe EDHEC Risk and Asset Management Research Centre structures all of its research work around asset allocation. This issue corresponds to a genuine expectation from the market. On the one hand, the prevailing stock market situation in recent years has shown the limitations of active management based solely on stock picking as a source of performance.

40% Strategic Asset Allocation

3.5% Fees

11% Stock Picking

45.5 Tactical Asset Allocation

Percentage of variation between funds

Source: EDHEC (2002) and Ibbotson, Kaplan (2000)

On the other, the appearance of new asset classes (hedge funds, private equity), with risk profiles that are very different from those of the traditional investment universe, constitutes a new opportunity in both conceptual and operational terms. This strategic choice is applied to all of the Centre's research programmes, whether they involve proposing new methods of strategic allocation, which integrate the alternative class; measuring the performance of funds while taking the tactical allocation dimension of the alpha into account; taking extreme risks into account in the allocation; or studying the usefulness of derivatives in constructing the portfolio.

An applied research approachIn an attempt to ensure that the research it carries out is truly applicable, EDHEC has implemented a dual validation system for the work of the EDHEC Risk and Asset Management

Research Centre. All research work must be part of a research programme, the relevance and goals of which have been validated from both an academic and a business viewpoint by the Centre's advisory board. This board is made up of both internationally recognised researchers and the Centre's business partners. The management of the research programmes respects a rigorous validation process, which guarantees the scientific quality and the operational usefulness of the programmes.

To date, the Centre has implemented six research programmes:Asset Allocation and Alternative Diversification Sponsored by SG Asset Management and Newedge

The research carried out focuses on the benefits, risks and integration methods of the alternative class in asset allocation. From that perspective, EDHEC is making a significant contribution to the research conducted in the area of multi-style/multi-class portfolio construction.

Performance and Style AnalysisPart of a business partnership with EuroPerformanceThe scientific goal of the research is to adapt the portfolio performance and style analysis models and methods to tactical allocation. The results of the research carried out by EDHEC thereby allow portfolio alpha to be measured not only for stock picking but also for style timing.

Indices and BenchmarkingSponsored by Af2i, Barclays Global Investors, BNP Paribas Investment Partners, NYSE Euronext, Lyxor Asset Management, and UBS Global Asset ManagementThis research programme has given rise to extensive research on the subject of indices and benchmarks in both the hedge fund universe and more traditional investment

About the EDHEC Risk and Asset Management Research Centre

EDHEC is one of the top five business schools in France.

Its reputation is built on the high quality of its faculty (110

professors and researchers from France and abroad) and

the privileged relationship with professionals that the school has been developing since its

establishment in 1906. EDHEC Business School has decided

to draw on its extensive knowledge of the professional

environment and has therefore focused its research on themes

that satisfy the needs of professionals. EDHEC is

also one of the few business schools in Europe to have received the triple

international accreditation: AACSB (US-Global), Equis

(Europe-Global) andAssociation of MBAs

(UK-Global).EDHEC pursues an active

research policy in the field of finance. The EDHEC Risk and Asset Management Research Centre carries out numerous research programmes in the areas of asset allocation and

risk management in both the traditional and alternative

investment universes.




classes. Its main focus is on analysing the quality of indices and the criteria for choosing indices for institutional investors. EDHEC also proposes an original proprietary style index construction methodology for both the traditional and alternative universes. These indices are intended to be a response to the critiques relating to the lack of representativeness of the style indices that are available on the market. In 2003, EDHEC launched the first composite hedge fund strategy indices.

Asset Allocation and DerivativesSponsored by Eurex, SGCIB and the French Banking FederationThis research programme focuses on the usefulness of employing derivative instruments in the area of portfolio construction, whether it involves implementing active portfolio allocation or replicating indices. “Passive” replication of “active” hedge fund indices through portfolios of derivative instruments is a key area in the research carried out by EDHEC. This programme includes the “Structured Products and Derivatives Instruments” research chair sponsored by the French Banking Federation.

Best Execution and Operational PerformanceSponsored by CACEIS, NYSE Euronext, and SunGard This research programme deals with two topics: best execution and, more generally, the issue of operational risk. The goal of the research programme is to develop a complete framework for measuring transaction costs: EBEX (“Estimated Best Execution”) but also to develop the existing framework for specific situations (constrained orders, listed derivatives, etc.). Research also focuses on risk-adjusted performance measurement of execution strategies, analysis of market

impact and opportunity costs on listed derivatives order books, the impact of explicit and implicit transaction costs on portfolio performances, and the impact of market fragmentation resulting from MiFID on the quality of execution in European listed securities markets. This programme includes the “MiFID and Best Execution” research chair, sponsored by CACEIS, NYSE Euronext, and SunGard.

ALM and Asset ManagementSponsored by BNP Paribas Investment Partners, AXA Investment Managers and ORTEC FinanceThis research programme concentrates on the application of recent research in the area of asset-liability management for pension plans and insurance companies. The research centre is working on the idea that improving asset management techniques and particularly strategic allocation techniques has a positive impact on the performance of asset-liability management programmes. The programme includes research on the benefits of alternative investments, such as hedge funds, in long-term portfolio management. Particular attention is given to the institutional context of ALM and notably the integration of the impact of the IFRS standards and the Solvency II directive project. It also aims to develop an ALM approach addressing the particular needs, constraints, and objectives of the private banking clientele. This programme includes the “Regulation and Institutional Investment” research chair, sponsored by AXA Investment Managers, the “Asset-Liability Management and Institutional Investment Management” research chair, sponsored by BNP Paribas Investment Partners and the "Private Asset-Liability Management" research chair, in partnership with ORTEC Finance.




Seven Research Chairs have been endowed:

Regulation and Institutional InvestmentIn partnership with AXA Investment ManagersThe chair investigates the interaction between regulation and institutional investment management on a European scale and highlights the challenges of regulatory developments for institutional investment managers.

Asset-Liability Management and Institutional Investment ManagementIn partnership with BNP Paribas Investment PartnersThe chair examines advanced asset-liability management topics such as dynamic allocation strategies, rational pricing of liability schemes, and formulation of an ALM model integrating the financial circumstances of pension plan sponsors.

MiFID and Best ExecutionIn partnership with NYSE Euronext, SunGard, and CACEIS Investor ServicesThe chair looks at two crucial issues linked to the Markets in Financial Instruments Directive: building a complete framework for transaction cost analysis and analysing the consequences of market fragmentation.

Structured Products and Derivative InstrumentsSponsored by the French Banking Federation (FBF) The chair investigates the optimal design of structured products in an ALM context and studies structured products and derivatives on relatively illiquid underlying instruments.

Financial Engineering and Global Alternative Portfolios for Institutional InvestorsSponsored by Morgan Stanley Investment Management The chair adapts risk budgeting and risk management concepts and techniques to the specificities of alternative investments, both in the context of asset management and asset-liability management.

Private Asset-Liability ManagementIn partnership with ORTEC FinanceThe chair will focus on the benefits of the asset-liability management approach to private wealth management, with particular attention being given to the life cycle asset allocation topic.

Dynamic Allocation Models and new Forms of Target Funds for Private and Institutional Clients In partnership with Groupe UFGThe chair consists of academic research that will be devoted to the analysis and improvement of dynamic allocation models and new forms of target funds.

The EDHEC PhD in FinanceThe PhD in Finance at EDHEC Business School is designed for professionals who aspire to higher intellectual levels and aim to redefine the investment banking and asset management industries.

It is offered in two tracks: a residential track for high-potential graduate students who will hold part-time positions at EDHEC Business School, and an executive track for practitioners who will keep their full-time jobs.

Drawing its faculty from the world’s best universities and enjoying the support of




the research centre with the most impact on the European financial industry, the EDHEC PhD in Finance creates an extraordinary platform for professional development and industry innovation.

Research for BusinessTo optimise exchanges between the academic and business worlds, the EDHEC Risk and Asset Management Research Centre maintains a website devoted to asset management research for the industry:(www.edhec-risk.com), circulates a monthlynewsletter to over 200,000 practitioners,

conducts regular industry surveys and consultations, and organises annual conferences for the benefit of institutional investors and asset managers.

The Centre’s activities have also given rise to the business offshoots EDHEC Investment Research and EDHEC Asset Management Education.

EDHEC Asset Management Education helps investment professionals to upgrade theirskills with advanced risk and asset management training across traditional and alternative classes.

Industry surveys: comparing research advances and industry best practices EDHEC regularly conducts surveys on the state of the European asset management industry. They look at the application of recent research advances within investment management companies and at best practices in the industry. Survey results receive considerable attention from professionals and are extensively reported by the international financial media.

Recent industry surveys conducted by the EDHEC Risk and Asset Management Research Centre

The EDHEC European ETF Survey 2008 sponsored by iShares

The EDHEC European Investment Practices Survey 2008 sponsored by Newedge

EDHEC European Real Estate Investment and Risk Management Survey 2007

sponsored by Aberdeen Property Investors and Groupe UFG

EuroPerformance-EDHEC Style Ratings and Alpha League TableThe business partnership between France’s leading fund rating agency and the EDHEC Risk and Asset Management Research Centre led to the 2004 launch of the EuroPerformance-EDHEC Style Ratings, a free rating service for funds distributed in Europe which addresses market demand by delivering a true picture of alpha, accounting for potential extreme loss, and measuring performance persistence. The risk-adjusted performance of individual funds is used to build the Alpha League Table, the first ranking of European asset management companies based on their ability to deliver value on their equity management.www.stylerating.com

EDHEC-Risk websiteThe EDHEC Risk and Asset Management Research Centre’s website makes EDHEC’s analyses and expertise in the field of asset management and ALM available to professionals. The site examines the latest academic research from a business perspective, and provides a critical look at the most recent industry news.www.edhec-risk.com



About Newedge Global Prime Brokerage

Newedge Global Prime Brokerage group is a global, multi-disciplinary, team-oriented solution-providing organisation dedicated to delivering superior services to alternative investment industry participants such as investors and fund managers.

Newedge offers a global range of brokerage activities on a wide range of asset classes including equities, bonds, currencies, commodities, and their related listed & OTC derivative products. The team also provides a dedicated account management team, cross-margining tools between securities & derivative instruments, hedge fund start-up services, hedge fund industry quantitative information and capital introductions services.

Newedge is a major new force in finance, resulting from the merger of the two brokerage firms – Calyon Financial and Fimat – on January 2nd, 2008. This makes Newedge unique among prime brokers: we are supported by these two AA- rated institutions yet remain independently managed and regulated. Our independence from the trading activities of the two banks minimizes potential conflicts of interest.

With over 3,000 employees in 26 of the world’s top financial centers, Newedge is a global organization and has access to more than 80+ global derivative and stock exchanges. Newedge is committed to transparency, integrity and rigorous ethical standards. Our role as a dedicated broker combined with our unique governance model help us minimize conflicts of interest. Newedge works in a

spirit of partnership. Relations with our customers, and between our multinational teams, are based on mutual respect, valued contribution, and trust.

Newedge Group (UK Branch)10 Bishops SquareLondon E1 6EGTel. +44 (0) 207 676 85 36Fax +44 (0) 207 676 81 45

www.newedgegroup.com/primebrokerage

EDHEC Risk and Asset ManagementResearch Centre393-400 promenade des AnglaisBP 311606202 Nice Cedex 3 - FranceTel.: +33 (0)4 93 18 78 24Fax: +33 (0)4 93 18 78 41E-mail: [email protected]: www.edhec-risk.com

E-mail: [email protected]

Hong Kong: Kirby Daley +852 2848 3368Singapore: Yves Marcel +65 63497530Paris: Frederic Lefevre +33 1 5507 3567London: Duncan Crawford +44 (0)20 7676 85 04New York: Jonathan Gane +1 646 557 7966

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