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Bringing Greater Transparency To Hedge Fund Analysis

By: Michael Markov

The increase in interest in alternative investments has also prompted calls for more transparency into these assets and strategies. Michael Markov, of Markov Processes International, LLC, examines one approach.

Institutional investors around the world committed more than $12 billion to hedge funds and hedge fund-of-funds in the first half of 2005. Several large public plans are ready to make their first investment in hedge funds this year including The New Jersey State Division of Investment, which is looking to allocate a portion of the stateʼs $68 billion public employeesʼ pension plan, and the $10.6 billion IllinoisState Board of Investment, which is seeking to invest five per cent of its total assets, $530 million, in hedge funds.

The explosion of investment in alternative strategies by institutional investors, plan sponsors, and pension fund managers has prompted a call for greater due diligence and a demand for heightened processes, documentation, and thorough analysis. Because alternative investments rarely offer the kind of transparency and information that institutional investors have come to expect from mutual funds and traditional separate accounts, it is critical that investment professionals have the right tools available to uncover hidden risks, verify manager strategies, and provide protection from fraud. Now, more than ever, plan sponsors and pension fund managers are seeking solutions that undeniably demonstrate to their constituents that due diligence is being performed.

Lightly regulated and often secretive investment pools, hedge funds require a heightened degree of scrutiny as institutional investors demand more information on the strategies, tactics, and returns of these funds than the wealthy individuals that previously dominated investment in them.

This, coupled with the long-awaited amendments to the U.S. Employee Retirement Income Security Act which are expected to relax conflict-of-interest rules and open the doors for broader use of hedge funds, is certain to attract more institutional money. Consequently, additional insight on the underlying style and approach of asset class managers will be imperative and serve to drive the adoption of research, reporting, and analysis tools by institutional investors to show that they are doing everything possible to protect their investors and satisfy their responsibilities.

What solutions are available to institutional plan managers, fund analysts, and fund of funds managers who seek analysis tools that specifically address these complex investment vehicles while satisfying the call for due diligence and transparency? A variation on Returns-Based Style Analysis (RBSA) may hold the answer.

bridging transparency

Returns-Based Style Analysis

First introduced by Nobel Laureate William F. Sharpe in the 1988 Investment Management Review article, ʻDetermining a Fundʼs Effective Asset Mix,ʼ RBSA has become a mainstay in the institutional world, evolving into essential methods and modeling tools for risk management, style drift analysis, attribution analysis, and performance measurement – fundamentally changing the way many investment analysts assess the behavior of money managers.

Traditional RBSA is a constrained optimization technique that identifies the combination of long positions in passive indices that most closely replicate the actual performance of a fund over a specifi ed time period. The passive indices selected typically represent distinct investment styles within particular asset classes. The longonly requirement for the replicating portfolio (also referred to as ʻnon-negativity constraintsʼ) results in relatively stable allocations to indices that are less susceptible to multi-colinearity – which often plagues standard regression techniques. In addition, the results are easily interpreted since the fund is replicated with a long-only portfolio of investible benchmarks. Thus, a purely mathematical phenomenon of constrained optimizations contributed to RBSA robustness and practicality results.

As a mutual fund analysis technique, RBSA is an informative, timely, and cost effective analytical tool for investors and plan managers interested in creating more relevant benchmarks and assessing the asset allocation implications of their mutual fund choices.

But obstacles arise when investors seek to apply the same technique to hedge funds. Conventional RBSA tools are ill-equipped to gauge if a hedge fund is being managed in a manner that is consistent with the stated approached (due to frequent use of leverage and shorting, often rapid market timing decisions, the lack of accurate historical data, and limited disclosure requirements).

Next-Generation RBSA

Until recently, the applicability of returns based analysis to alternative investment products was relatively limited. As compared with traditional investments, hedge funds may take significant short positions, employ leverage, and engage in very rapid, almost instantaneous, strategy changes with the help of derivatives. Unfortunately, customary ʻwindow-basedʼ regression techniques are limited in their ability to handle these complex investments.

Once the long-only requirement is lifted in the analysis so that both long and short positions are allowed into the tracking portfolio of indices, the regression results become wildly unstable, making them difficult to interpret and trust.

To address the limitations of traditional RBSA in dealing with hedge funds, leading research analysis and reporting companies have delivered software solutions that strive to offer the same level of transparency and insight as with traditional funds.

These processes are designed to improve the returns-based analysis of hedge funds and overcome traditional RBSA difficulties in analyzing alternative investments, improving risk assessment, fraud detection, and transparency. They may also allow plan managers and other financial professionals to understand the source of a fundʼs performance and to verify if it matches with its stated strategy.

bridging transparency

Radical Shift

Sharpe himself acknowledged the limitations of traditional RBSA in the 1997 article ʻOld Controversy Reignites Over Returns- Based Analysisʼ in Pensions & Investments saying, “In most instances, returns based analysis wonʼt notify you immediately of a radical shift in investment style.”

With these new models, complex and elaborate strategies can often be explained by a handful of factors. Essentially an analyst can perform risk management responsibilities and gain excellent transparency through using the monthly returns of the manager. It should be noted, however, that daily returns and returns broken down into long and short components can also be obtained from the managers themselves.

For example, Markov Processes International has a patent-pending solution, Dynamic Style Analysis (DSA) which is based on pattern-recognition technology and overcomes traditional RBSA difficulties in analyzing alternative investments, improving risk assessment, fraud detection, and transparency. This model allows plan managers and other fi nancial professionals to understand the source of a fundʼs performance and to verify if it matches with its stated strategy.

In contrasting the DSA approach with traditional RBSA, one can see the superior smoothness of the analysis, noise reduction, and avoidance of spurious correlations in Figure 1, a monthly analysis of a market neutral portfolio. Analysis of the same fund using DSA results in both much smoother and realistic allocations (Figure 2) and a very close tracking by the portfolio of indices (blue line) of the fund (red line Figure 3). Figure 3 demonstrates how the DSA style portfolio (in blue) tracks the return behaviour of the managerʼs actual monthly returns (in red). In Figure 4, the blue DSA style portfolio explains the return behaviour of the managerʼs actual performance which is shown in red.

These new tools can help ʻreverse-engineerʼ hedge funds by applying new RBSA methodologies for better transparency, risk assessment, and fraud detection. In doing so, plan sponsors and institutional investors can rest easy knowing the fundʼs performance numbers match the story of its managers. This is especially important in todayʼs climate of heightened due diligence. Hedge fund investors, including pension fund managers, plan sponsors, and their analysts, must have the best technology solutions available to better understand their investment options and, if necessary, to defend their decisions.

Michael Markov is the co-founder, CEO, and director of research for Markov Processes International, LLC.

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