Why valuing hedge funds is tricky

This article originally appeared on benefitscanada.com

In 2012, 40% of institutional investors invested directly in hedge funds, compared to 24% in 2010, said Catherine Thrasher, managing director of BNY Mellon Performance & Risk Analytics, at a speaking event last week.

Overall, she says an increasing number of investors are looking into hedge funds due to the promise of higher returns.

But they have to be cautious, as these funds are difficult to valuate and benchmark.

Read: Are hedge funds suitable for the average investor?

Performance management

It’s easy to calculate the value and performance of traditional assets such as equities. It’s not quite as easy, though, to calculate the value of hedge funds.

“Calculations are slower and subject to revisions,” says Thrasher. The net asset value (NAV) of securities, for example, is struck on a monthly, even daily basis. With hedge funds, the value is typically struck on a quarterly basis.

This means more work for investors. “It becomes more operational [for them]; they have to be involved in that process more,” she adds.

While some hedge fund managers have a better infrastructure in place to suppress this valuation issue, she says, “The vast majority of them are quite slow, and it’s a quarterly process.”

Read: 4 facts about hedge funds

Benchmarks

Hedge fund benchmarks aren’t constructed like those of securities, where the benchmark comprises the securities traded on a particular stock exchange.

Instead, hedge fund benchmarks are comprised of the current funds submitting data to places like the Hedge Fund Research Institute. The institute creates a universe of hedge funds using this limited information, says Thrasher.

The main problem, she adds, is these benchmarks also suffer from survivorship bias.

Since new hedge funds are created all the time, there is a high degree of turnover in the asset class. And, as a result, the poor performers are dropped out of the universe routinely. This leaves only the better funds in the universe and, thus, it’s artificially inflated, she says.

Read: Beware peer group analysis, for more on survivorship bias

When a hedge fund manager compares their performance to that universe, they look worse by comparison.

Compliance monitoring

Equity managers follow a Statement of Investment Policies and Procedures (SIP&P), which details the percentage an investor has in a particular stock or sector, among other directives, says Thrasher.

Hedge fund managers don’t follow this practice. “There hasn’t been the regular oversight [with hedge funds] that we’ve seen with other asset classes,” she says.

She adds that this is one of the main reasons pension boards and investors are uncomfortable with hedge funds. [When invested in one], you don’t get the underlying securities holdings to be able to see that amount of depth and detail in the fund.

“Typically, you see that NAV level and the total fund price, but that’s as much transparency as [you get].”

The good news is this is starting to change. Institutional investors can get the underlying holdings and the independent oversight for their hedge funds through a managed account platform, for example.

Read: The future is in managed accounts

If you think of the Madoff hedge fund, that team priced the securities, priced the fund, traded the fund and calculated its own performance; “they controlled every aspect of the fund, which isn’t good governance,” says Thrasher.

Read: Don’t be fooled by the next Madoff

The managed platform, on the other hand, takes the hedge fund manager out of this position. They hire an independent third party to price securities, as well as run compliance and write the investment manager guidelines, she says.

“[Managed accounts] separate the hedge fund manager from the cash movement to try to prevent the fraud we’ve seen in the industry. The hedge fund manager is managing the fund and making those investment management decisions, but that’s it.”

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