By Ken Akoundi
Desperate for returns, many pension plan sponsors and other institutional investors have abandoned, in their hedge fund investments, fundamental best practices established for other asset classes, especially transparency
When sponsors and other investors demand transparency from hedge fund managers, many managers claim they provide it. But until each side decides what transparency means, the concept will remain nebulous, and the various parties will continue talking past each other.
Many managers and consultants argue that investors, especially the plan sponsors, would have no use for transparency. These pundits are correct to point out that plan sponsors have no use for daily position files. Where they are wrong is in their self-serving definition of transparency.
Transparency must be redefined as transparency of risk without transparency of positions. This can manifest itself as a series of well-thought-out single dimensions of risk and exposure reports that enable the investor to create a mental multidimensional picture of risk. Transparency is about getting intelligence on your portfolio, not just data.
Another factor often overlooked is frequency. The transparency process does begin with the ability to get hold of a hedge fund's positions. However, it does not stop there. Getting positions from individual managers is worthy, but must be accomplished at regular intervals. The discipline of collecting data on a regular basis, feeding them through a robust process and getting numbers that relay intelligence, provides insight into a composition of the portfolio, as well as its evolution over time (to potentially alert the investor of unintended changes in strategy).
Many institutional investors pride themselves that their managers provide them with their positions (a.k.a., transparency) which are manually put through a Bloomberg terminal to obtain a "reassuring" risk measure (e.g., value at risk, or VaR). This kind of undisciplined process introduces at least two types of risk, potentially more catastrophic than the market risk they are trying to measure: operational risk due to manual intervention; and model risk because of Bloomberg's linear approximations that are inappropriate for non-linear instruments. Transparency is about measuring risk, not about swapping one risk for another.
Transparency must also be defined as the automated process of position collection, cleaning, analytic valuation and generation of reports. In this context, it bears an important unintended consequence: It forces an independent discipline into the process. This discipline, when enforced across billions of dollars, enables the plan sponsor to get a comparative estimation of its assets' value. For instance, a manager that consistently values its assets 25% above the average value of five other managers that trade the same strategy will stand out. Transparency is about a disciplined and independent valuation process.
Even when a hedge fund agrees to submit its position through a transparency process, it is necessary to discuss and understand what models are used in valuation, by both the manager and transparency provider. This requires competencies that investors might not have in-house, such as valuation models, technology and processes. Transparency is about outsourcing to and trusting those who have built core competencies.
For a transparency service to be successful, risk must be standardized. Transparency must include standardized and transparent processes, models, as well as formats, so the investor can easily compare managers and their strategies.
The entities that manage the transparency process must be independent of other sell- and buy-side institutions. The only way to avoid the kind of well-documented conflicts that have plagued the pension consultants and their catering to the asset management world is to make sure that the service provider's independence has no chance of being compromised. Transparency should preferably be provided by an independent entity.
Transparency must include robust methodologies and scalable technologies. The technology component of transparency is often overlooked. A risk system must be designed to be fast and accurate at the same time.
Sometimes, managers argue that demanding transparency will affect returns. There is no conclusive evidence of such a phenomenon. Which one is more likely: that the returns are diminishing because of the increased number of managers (with reduced quality) and diminishing arbitrage opportunities, or that the managers are providing transparency? Transparency must not be compromised and must be required as part of best practices.
Ken Akoundi is co-head of risk management, Optima Fund Management LLC, New York.