NEW YORK - Rating agencies Standard & Poor's Corp. and Fitch Inc. are looking into providing hedge fund and fund of funds managers with ratings as a way to make them more palatable as investment vehicles.
But even as hedge fund firms and the rating agencies look into the issue, hedge fund of funds managers and others question how effective ratings ultimately will be.
"It's not like rating the city of New York or Verizon," said Raymond E. Ix Jr., senior vice president of Mount Lucas Management Corp., a Princeton, N.J., managed futures trading firm. "Manager portfolios change every day."
Mr. Ix said hedge funds, by the complexity of their investment processes, pose challenges to agencies attempting to assign ratings based on trading strategies, risk management, volatility and other factors. He also questioned whether ratings agencies, which are used to analyzing corporations and countries, have the capability to peer into hedge funds or funds of funds and pull information needed to rate them or their performance individually.
"I think investment consulting firms are better suited to doing that kind of analysis," Mr. Ix said. "The way hedge funds are defined, you can be anything. You can get rated as a convertible arbitrage manager, and then put on a huge short U.S. interest rate position. What will inevitably happen is that a hedge fund manager will have his rating downgraded."
Look at the credit
D. Sykes Wilford, chief investment officer at hedge fund manager CDC Investment Management Corp., New York, said an easier - and more informative - way to rate hedge funds is to rate the fund's credit. CDC years ago had a rating on a fixed-income strategy fund that was based on the instruments in the fund, not the fund's performance.
Mr. Wilford said looking at the instruments and rating the credit ultimately tells the investor more about the fund than trying to analyze and rate the fund based on performance.
"If the instruments in the fund are all triple-A instruments, it tells the investor that this is not a fund that goes and buys a lot of junk and props it up with Treasuries," Mr. Wilford said.
John Schiavetta, managing director at Fitch in New York, said the company has rated various kinds of hedge fund and hedge fund of funds debt issuances. These have included collateralized debt obligations, which are complex securities backed by a portfolio of bonds, loans and other assets. Hedge funds take out loans to increase their leverage. Fitch assigns ratings to the capital structure of the debt, not necessarily to the hedge fund per se, Mr. Schiavetta said.
In one case, Fitch gave what's called a counterparty rating to two hedge funds run by Citadel Investment Group, Chicago. Counterparty ratings are assigned to financial institutions as a measure of their creditworthiness when the institution has no specific outstanding debt that can be rated, Mr. Schiavetta said.
To arrive at a counterparty rating, Fitch studies factors like market volatility, the market risk of the investment strategies, risk management processes, operational risks, the strength and depth of management, the institution's track record and legal risks.
"Most of it really comes down to risk management and how well you feel about the infrastructure of the firm," Mr. Schiavetta said.
But so far, most hedge funds have not been interested in providing the transparency needed to obtain a counterparty rating.
Counterparty ratings
Following its counterparty rating of Citadel's hedge funds, Fitch got some "general inquiries" from other hedge funds about obtaining counterparty ratings. Mr. Schiavetta would not say if Fitch has issued other ratings to hedge funds, but did add that relatively few hedge funds would qualify for a high enough rating to make the transparency worthwhile.
"Only the best (hedge funds) could really get into the triple-B range, so it's a limited market at this stage," Mr. Schiavetta said.
Although he foresees a time when ratings companies could rate individual hedge funds and managers on investibility, for now Fitch will stick to rating hedge fund and fund of funds debt and collateralized debt obligations.
Fitch in November announced a fixed ratings system for collateralized debt obligation asset managers. Such ratings are used by potential buyers of the hedge fund debt to determine creditworthiness of that debt. The same ratings can, by extension, be used to assess the hedge fund or fund of funds themselves, Mr. Schiavetta said.
"My impression is that the (investors) can take some comfort that even though a rating on the hedge fund's debt or collateralized debt obligation technically speaks to the debt issuance, part of the process includes an assessment of the hedge fund manager," Mr. Schiavetta said. "To the degree they've passed that process and Fitch is comfortable with their processes, to some degree that's transferable (to the hedge fund itself)."
Quality attempt
Fund of funds manager Ferrell Capital Management, Greenwich, Conn., looked into obtaining a quality rating for a multimanager, multistrategy fund focusing on fixed income and currencies a few years ago, said Philip S. Douthit, director of research and development. Such a rating would have been based on the fund's risk controls, its processes and procedures, Mr. Douthit said.
"That might have had some, but not a whole lot of impact," Mr. Douthit said.
Instead, Ferrell chose to get a rating from Fitch on the senior debt Ferrell used to leverage the structured product strategy.
So far, getting a rating on investment instruments or debt has been the most popular way to go for those hedge funds and fund of funds that have elected to receive ratings. But that could be changing.
As more institutional investors consider and invest in hedge funds, more managers have been entering the market. Obtaining a rating of the fund itself based on its processes, risk controls and volatility might be a way for a fund manager to shine above the rest of the pack.
Phil Edwards, managing director of fund services at New York-based Standard & Poor's, said the company has issued both counterparty and debt ratings to hedge funds. The company, he said, is looking into rating individual hedge funds and hedge fund managers.
"We are thinking about that possibility, but we haven't taken any public action on that," Mr. Edwards said. "It's something we think we can add value to the market."
S&P's criteria
Among the things S&P would examine for such a rating would be quality and depth of management at the hedge fund, clarity of philosophy, consistency of process, performance and infrastructure.
"In a nutshell, we would look at what the manager is saying he or she is doing, how they implement that and whether they are being consistent with it," Mr. Edwards said.
Two hurdles S&P needs to overcome are understanding the various hedge fund strategies and getting enough information from the hedge fund managers to make an assessment, Mr. Edwards added.
He said S&P has no timeline for rolling out individual manager and hedge fund ratings. He said investor demand spurred the firm to look into the area.
