Why can’t a fund manager simply subtract all fees and expenses from gross returns and present the arithmetical result to existing or potential investors? In a newly released paper, Donald Steinbrugge, the founder and CEO of Agecroft Partners, discusses how hedge funds calculate and present their net performance, and the need for standardization in this area. The issue isn’t arithmetic. It’s transparency.
Steinbrugge’s discussion was spurred by the work of the Chartered Financial Analyst Institute, which will likely announce performance presentation standards for the industry some time in 2019. He hopes these standards will, when announced, “benefit hedge fund managers by leveling the playing field on which they compete,” and benefit investors by providing consistent information so they can decide in a rational way which funds do or don’t belong in their portfolios.
Beyond the Worst Case
Currently some risk disclosure consistency does exist, but that is driven by lawyers seeking to limit their client’s liability by presenting worst-case scenarios. That does not provide much by way of clarity. Going beyond that, what can and should the industry do?
Going back to why a fund manager can’t simply subtract all fees and expenses from gross returns and present the arithmetical result. Suppose for example that a hedge fund is launched with internal capital and runs with that money for two years before it opens to external capital. In this scenario, some funds will simply show potential investors the net performance of the fund. There’s an obvious objection to that. It will inflate net return and so give a falsely optimistic impression of that performance, and thus of the manager’s skill level, since the manager hasn’t had to pay fees.
Another approach: some managers will calculate their performance on the assumption that all assets have paid full management and performance fees since operations began.
If two funds with identical performance are competing with one another, with these two distinct approaches to reporting, the more transparent will have put itself at a considerable competitive disadvantage. If each fund earns a 10% gross return and charges external investors a 1.5% management fee and a 20% performance fee, the difference in presented performance will annualize to 3% for those first two years.
In another scenario, a hedge fund might be launched with a reduced founder’s share class with just a 1% management fee and a 10% performance fee. The fund reaches a threshold level of assets, that share class is closed and new investors (non-founders) are charged 1.5% and 20%. Again, the issue is how the fees should be factored into the calculation of performance.
With regard to such scenarios, Agecroft contends that “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.” Further, when fees are raised or lowered, management should restate historical performance based on the currently available fees. They would provide for an exception where the change in fees coincides with a major change in how the fund is managed.
Separate Accounts, Valuation, and Liquidity
There are other important issues. Among them, separate accounts and “funds of one.” Twenty years ago, Steinbrugge writes, most hedge fund industry assets under management were invested in commingled funds. Today, separate accounts and “funds of one” in the funds of hedge funds space, are quite common. Investors, he says, “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.” He suggests the extension of the Global Investment Performance Standards (GIPS), which have been around since 1999, and were revised in 2005. The GIPS were created with long-only entities in mind, but Agecroft envisions their application to the separate accounts and funds-of-one accounts of hedge fund organizations.
There is also the fraught question of securities valuation. Performance disclosures should describe how the valuations are done and whether there is a third-party validation. With valuation must come an explicit treatment of liquidity. Managers should note that their valuation of less liquid securities can have the effect of smoothing out return streams with an impact on a lot of metrics used by investors: Sharpe ratios, correlations, and tail risk.
Agecroft’s concern is with the consistency of data and communication across the industry. This would be eased by the creation of a “recommended format in which the various categories of disclosure are addressed,” and a standardization of language, in order that their significance will be easy to understand.