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Closing the Investor-Manager Gap on Hedge Fund Transparency

By Michael S. Fischer

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Since the financial crisis, hedge fund investors have demanded more transparency, and managers have worked to meet those demands without betraying their proprietary strategies to competitors.

However, a recent study by Northern Trust Hedge Fund Services found a huge gap in investors’ and managers’ perceptions of whether industry changes have been sufficient.

The study found that 55% of hedge fund investors wanted more or substantially more transparency from their investments, while 98% of managers thought all or substantially all of their investors were satisfied with the level of transparency they were receiving.

According to the study, two factors accounted for this gap. Managers sought to protect their proprietary strategies, while investors found that traditional levels of transparency, such as month-end sector transparency, did not help them understand exposures and hidden risks in their portfolios.

Moreover, investors who adopted managed accounts that gave them total transparency were often unable to take advantage of the information as a means of holistic risk management.

Risk aggregators that would provide trade-level information “are realistic only for the largest investors,” the report said.

Northern Trust, with Asset International, conducted an online survey in September of 303 international investors and managers of 118 hedge funds, 192 investors and 70 managers in North America.

How to Achieve Consensus

The report said closing the transparency gap would require the development of new ideas for data management and new market practices, changes that are within reach because of technology advances and the maturation of the hedge fund industry.

A consensus solution, it said, would have to accomplish four things:

  • Aggregation: Capturing data from various sources, centralizing the data and providing a presentation and data delivery layer
  • Normalization: Translating and formatting data from each source consistently by sourcing missing values
  • Verification: Validating received data’s accuracy through reconciliations, overriding valuations where needed, running data quality checks and resolving any issues or discrepancies
  • Integration: Integrating systems, business processes and data delivery formats to enable seamless delivery to external systems and make the aggregated data source the “golden copy” of data for counterparties

The report said integration was arguably the most important of these goals. Managers are seeking the value and convenience of a consolidated portfolio view, but need solutions that allow them to use their own portfolio construction, risk management, compliance and performance systems.

And sophisticated investors would benefit from data that could be integrated into their analysis processes, allowing them to better understand portfolio-wide risk and exposure, and better model the implications of shifts in their overall investment strategy. Developing systems and services that address aggregation, normalization, verification and integration has the potential to be used by the hedge fund industry to create solutions that meet the needs of both parties.

Managers who can affordably implement better and more expansive validation procedures get both better data and the ability to compete on controls, differentiating them in the eyes of increasingly risk-conscious investors.

And better and more affordable data integration capabilities enable managers to offer investors the detailed risk-factor and exposure based information they want, while protecting the intellectual property of their trading strategies by keeping position and transaction data confidential.

The report acknowledged that formulating an industry standard for data integration was an ambitious goal. But investors’ needs, an increasingly competitive marketplace, more complex financial markets and regulatory scrutiny demand integrated data solutions.

Adopting an industrywide integrated data model would not only help managers bridge the transparency gap with investors, the report said, but also would better position them to meet regulatory demands, facilitate data quality and generate new and compelling value propositions for investors by making their services a more integrated part of investor portfolios.

Early embracers of these trends will gain a strategic advantage in the competition for market share.

Managers will be able to differentiate on their ability to meet investor needs and attract more capital, and will in turn show favor towards administrators, brokers, technology providers and data vendors that help facilitate a more robust approach to data management.

— Check out SEC Private Fund Unit Focused on Conflicts, Real Estate Managers on ThinkAdvisor.