Missing the mark: CFA hedge fund performance standards
By Don A Steinbrugge (pictured), Agecroft Partners – The CFA Institute has released and circulated the final version of its guidelines to improve performance standards in the hedge fund industry. They will go into effect on 1 January, 2020. We strongly support the effort to create and implement performance standards in the industry and believe that the CFA Institute is the right organisation to lead this charge.
As we have seen in the long only investment industry, GIPS performance standards are well thought out and have been broadly accepted. The adoption of these standards has greatly improved investors’ ability to evaluate the relative attractiveness of managers. The standards also benefit investment managers by levelling the playing field to compete.
Unfortunately, we believe that these new performance standards for the hedge fund industry have missed the mark by failing to address some of the most important issues regarding hedge fund performance reporting. As such, we expect there to be minor acceptance of the new standards. We have had conference calls with the executive directors of the three main alternative investment associations and it appears that none of them will be publicly supporting the new standards.
Investors will ultimately decide on the acceptance and implementation of these performance standards. Unless the guidelines are viewed as value added by investors, fund managers will not be pressured to align their reporting with the new guidelines. Instead, they will continue to cast their fund in the best light possible, even if it deceives investors with respect to their attractiveness relative to other funds. Although we are disappointed with this initial version of these performance standards, we are confident that the CFA Institute will revise and enhance these standards over time to benefit all involved in the hedge fund industry.
Several months ago we published an article What Aren’t You Telling Me? Major Discrepancies in Hedge Fund Industry Reporting outlining many of the issues we saw with the draft performance reporting guidelines. Members of the CFA GIPS committee did agree to have a call to discuss our issues. Unfortunately we learned during the call that the comment period was over and they could not consider new comments. Here is an abridged version of that article, pointing out the four major issues which have not been adequately addressed in the final CFA’s performance standards.
1 Managers with identical expenses ratios, fee schedules and gross returns are presenting drastically different net performance and it often does not represent what a full fee paying investor would have received. This results from the average fees used to calculate net fund performance comprising non-fee paying general partner capital, low fee paying “founder’s shares”, fee discounts for large investors and fee discounts for longer lock ups. Here are three scenarios that illustrate the inconsistent ways various fund managers calculate performance:
A. 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% annualized during the first two years of the fund. This difference in performance is unacceptably misleading. While past performance does not guarantee the future results, this data is an important part of the fund selection process.
B. 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 restated from day one assuming all assets of the fund had paid the higher full fee schedule since the inception of the fund.
C. 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.
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. An alternative would be to disclose annual fees used to calculate net performance.
2 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 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.
3 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 DDQ’s typically articulate broad categories of expenses, they lack the granularity required for investors to really understand what fees they are paying. We believe investors should receive the fund’s expense ratio along with full disclosure on what 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.
4 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 organization within the hedge fund industry and, through their DDQ, has done a great job of standardizing 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.
Investors need consistency in how performance is calculated and presented, with enhanced disclosure, in order to make the best possible investment decisions. For hedge fund performance standard to be successful, they must be written for the benefit of the investors. This will also level playing field on which hedge funds compete and increase the credibility of the hedge fund industry. More thoroughly written guidelines 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.