By Donald A. Steinbrugge CFA, Founder and CEO of Agecroft Partners
The Chartered Financial Analyst Institute (CFA), one of the most important organisations in the investment industry, is expected to announce performance presentation standards for the hedge fund industry sometime later this year. Currently, they are formulating their recommendations and we applaud their efforts. Ideally, these standards should benefit hedge fund managers by levelling the playing field on which they compete, as well as investors, by providing consistent information that will enhance their investment decision making process. It is extremely important that the CFA Institute achieves both objectives in order to have broad adoption across the industry. Now is the time for the hedge fund industry to speak up. Agecroft Partners feels compelled to share our updated views on what we expressed earlier this year in an educational video hosted at the CFA Institute.
Today, there is no consistency across the hedge fund industry in how net performance is calculated and presented. There is some consistency in performance and risk disclosures, but they provide very little clarity. Most disclosures offer worst case scenarios as hedge fund law firms seek to limit their client’s liability. This does help keep less sophisticated investors away. Unfortunately, this type of disclosure provides limited information to be used by sophisticated investors to measure risk-adjusted performance across managers.
The most important issue that needs to be addressed is standardising how to calculate and present a hedge fund’s net performance. One might suggest simply subtracting all fees and expenses from gross returns. Unfortunately, most things are not as simple as they first appear. Here are four scenarios that illustrate the inconsistent ways various fund managers calculate performance:
1) A hedge fund is launched with non-fee-paying partner capital. After two years of managing internal capital only, they begin to add external capital to the fund.
Some hedge funds will show the net performance of the fund. This will overstate the manager’s skill level, since there were no fees charged for the first two years thereby inflating the net return. The average fee charged in later years will continue to be below the stated fees due to the non-fee-paying assets of the fund.
Other managers calculate their performance assuming that all assets in the fund paid full management and performance fees from day one.
The difference between these two approaches, assuming a 10% gross return and 1.5% management fee with a 20% performance fee, is more than 3% annualised during the first two years of the fund. This difference in performance is unacceptably misleading. While past performance does not guarantee the future, this data is an important part of the fund selection process.
2) A hedge fund is launched with a reduced fee founder’s share class at a 1% management fee and 10% performance fee. Once the fund reaches $150 million in assets, the founder’s share class is closed to new investors with the reduced fees grandfathered for current investors. New clients are required to pay full fees at 1.5% and 20%. In this situation, we have seen hedge funds calculate net performance in the following three ways:
Net performance of the fund includes the founder’s share performance in the early years and then adds the higher fee share class once the founder’s share is closed.
Net performance is calculated from day one assuming there was no founder’s share discount and full fees were paid on all assets in the fund. This approach puts the founder’s share class at an unfair marketing disadvantage if this share class is still open for subscriptions as investors in the founder’s share would have a higher net return than the full fee share class.
Performance is calculated net of the founders share fees until the share class is closed and then restating performance from day one assuming all assets of the fund had paid the higher full fee schedule since the inception of the fund.
3) A hedge fund manager charges a graded fee schedule, where average fees decline for larger allocations. Once again, there are multiple ways of calculating net performance, including the net performance of the fund or assuming all investors in the fund had paid the highest fee schedule.
4) A manager charges 2% management fee and 20% performance fee in the early years of the fund but decides to reduce their fee schedule to 1.5% and 20% to be more in line with market standards. This scenario creates the opposite pattern to that of the founder’s share class example (and something we expect to see more of in the future). In this scenario, presenting fund returns since inception understates net returns with respect to the fees currently charged.
Agecroft Partners believes the industry standard should be that hedge fund net performance reflects the current highest available fee schedule and assumes it is paid on all assets in the fund since its inception. If fees are raised or lowered, historical performance should be restated to reflect net performance since inception based on the currently available fees. The one exception would be if the change in fees coincided with a major change in how the fund was managed.
Other issues that should be addressed include:
Security valuation guidelines.
Performance disclosures should describe how valuations are determined and whether or not there is any third party validation of their accuracy. The disclosure should also describe the liquidity of the underlying investments in the fund. Many investors are attracted to less liquid securities because they often provide greater upside from pricing inefficiencies (in addition to an illiquidity premium). It is important to note that the valuation of less liquid securities can, at times, artificially smooth out return streams. This will, in turn, reduce the standard deviation of returns, increase Sharpe ratios, distort correlations, and understate potential tail risk. All of these statistics are among those used by investors in selecting hedge funds.
Expenses allocated to the fund.
These expenses can have a large impact on net performance and should be disclosed in greater clarity. There is a broad range across the hedge fund industry of what expenses are allocated to a fund. While Due Diligence Questionnaire’s typically articulate broad categories of expenses, they lack the granularity required for investors to really understand what fees they’re paying. We believe investors should receive the fund’s expense ratio along with full disclosure on what type of expenses are being allocated to the fund. This is particularly important to onshore investors who can no longer deduct fund expenses. With greater clarity, more hedge funds are likely to take a conservative approach to expense allocation and thereby increase net returns to investors.
Assets under management used to calculate performance. Most hedge fund strategies have asset capacity limitations beyond which performance will be negatively impacted. In an environment where most assets are flowing to the largest funds, investors need to see how a fund’s growth over time impacts performance.
How to handle performance for Separate Accounts and Funds-of-One.
Twenty years ago, most hedge fund industry assets were invested in commingled funds, with the exception of assets invested in commodity trading advisors (CTAs). Today, separate accounts and “funds of one” are much more common for large investors. We are not in favour of a single composite performance for a hedge fund organisation with multiple funds and/or accounts. However, investors should know if there are performance differences between investments in the commingled fund, and those in managed accounts and funds-of-one, and if so, why. This might be addressed by using Global Investment Performance Standards (GIPS), which was created by the CFA Institute for long only investment organisations. We could envision GIPS being applied to the separate accounts and fund-of-one assets of the hedge fund organisation.
Simulated track records.
There are broad differences in how simulated track records are created and what they represent. There are simulated records reflecting actual performance but different fees. Some simulated records illustrate how a leveraged version of their current (unlevered) strategy might have performed. Some quantitative managers show simulated back tested performance, which many people believe has significantly less credibility than returns based on an actual portfolio. We believe a firm should be able to show simulated performance as long as it is clearly marked on the performance page (potentially highlighted in red) and consistently described in the disclosures based on new industry standards. One exception would be for a track record created since inception assuming all assets pay full fees (which would be footnoted, but not need to be clearly marked as “simulated” on the performance page.)
The Alternative Investment Management Association (AIMA) Due Diligence Questionnaire (DDQ).
Hedge fund historical performance is one of many evaluation factors investors use to select a hedge fund. AIMA is a highly regarded organisation within the hedge fund industry and, through their DDQ, has done a great job of standardising how hedge funds communicate many issues that are important to investors. We believe the CFA Institute should leverage the work that AIMA has done by recommending in the performance disclosures that investors read both the hedge fund documents and an AIMA structured DDQ before investing.
Finally, in order to make performance disclosures easy to understand for the investor there should be a recommended format in which the various categories of disclosures are addressed. Additionally, where possible, we would support standardised language to ensure consistent communication across the industry.
All managers deserve a level playing field on which to compete. Investors need consistency in how performance is calculated and presented, with enhanced disclosure, in order to make the best possible investment decisions. The CFA Institute is composing performance standards for the hedge fund industry, which they expect to announce later this year. It is important the CFA Institute receives the best possible information to maximise the benefit of these upcoming performance standards for all stakeholders. This will increase the probability of these standards being broadly accepted throughout the hedge fund industry and thereby provide the much needed consistency that will benefit all market participants.
By Donald A. Steinbrugge CFA, Founder and CEO of Agecroft Partners