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Morningstar launches star ratings and indices for hedge funds

Investment research provider Morningstar has launched the Morningstar Rating for hedge funds as well as the Morningstar 1000 Hedge Fund Index and 17 indices based on the Morningstar Hedge Fund Categories.

Similar to the Morningstar Rating for mutual funds, the new rating system for hedge funds uses a scale of one to five stars so that similar numbers of hedge funds receive one and five stars.

Morningstar first categorises hedge funds into one of 17 Morningstar Categories, such as convertible arbitrage or emerging market equity, according to a series of quantitative and qualitative measures, then ranks and rates funds against their peers in the respective category based on risk-adjusted return.

The firm says the risk-adjusted return calculation and rating address two issues specific to hedge funds. First, unlike other risk-adjusted performance measures such as the Sharpe ratio, the Morningstar rating does not assume that funds have returns that follow the normal bell curve distribution.

Secondly, the rating addresses the fact that some hedge funds invest in illiquid securities that are infrequently priced. According to Morningstar, infrequent pricing gives hedge fund managers 'flexibility' in how they value such positions when calculating returns that they report to hedge fund databases, resulting in a smoother or less volatile reported return series. To correct for this, the firm applies a statistical procedure to the return series and then calculates a risk-adjusted return measure that accounts for all variations in a fund's monthly performance, with more emphasis on downward variations.

Morningstar's database includes around 7,700 single-manager hedge funds and funds of hedge funds. To qualify for a rating, single-manager funds must have at least 38 months of consecutive performance data. Funds of hedge funds, of which there are 3,300 in the database, are not eligible for ratings. Morningstar expects that around 1,800 of the 4,400 single-manager funds in its database will receive ratings.

The Morningstar 1000 Hedge Fund Index is a global, broadly representative benchmark for hedge fund performance composed of the top 90 per cent of eligible assets in the firm's hedge fund database. For the purposes of the index, Morningstar treats funds with shared portfolios as a single hedge fund; funds of hedge funds are excluded. The index is updated daily for the previous month-end, rebalanced monthly, and reconstituted semi-annually. Morningstar has also launched 17 category indices based on its strategy-specific classification system for hedge funds.

'We believe the Morningstar Rating for hedge funds is the best starting point for judging a fund's past performance,' says vice-president for research John Rekenthaler. 'We want to make researching hedge funds a more transparent process, and our new ratings and indices will allow investors, advisors and institutions better to evaluate and compare hedge funds with their peers.'

SGAM Alternative Investments, part of Société Générale Asset Management, has selected Morningstar to provide its institutional clients with hedge fund data, portfolio evaluation, analysis tools, indices, research, and ratings, and will provide customised hedge fund portfolio advisory services to institutional investors through SGAM's New York-based affiliate.

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