Randal Goldsmith outlines the process behind Standard & Poor's fund of hedge funds ratings service ...
Randal Goldsmith outlines the process behind Standard & Poor's fund of hedge funds ratings service
Rating and comparing funds of hedge funds (FoHFs) in all their permutations must often seem like herding cats - a thankless and nigh on impossible task. But for investors to make sense of the fast changing FoHF world, a robust system needs to be in place. Randal Goldsmith, associate director, fund ratings at Standard & Poor's Fund Services explains how S&P has gone about its FoHF ratings process.
Previous incarnations had pitted hedge funds and all their permutations against traditional long-only peer groups. As a stop-gap measure, the method was far from ideal. The equity downturn further highlighted the need for something more robust to measure the ability of FoHFs to generate absolute returns on a consistent basis.
Standard & Poor's first began rating long-only funds in 1990 and launched its FoHF ratings service in 2003. It currently screens from a universe of more than 600 FoHFs and that number continues to grow.
Goldsmith comments that a significant proportion of total funds under management in the FoHF sector is concentrated in just under 20% of the funds in the universe.
He goes on to say: "In this universe, the market is very, very skewed. Most of the funds are quite small and at the bottom end you tend to find the really small outfits and one-man-band operations."
Minimum Qualitative Criteria
The ratings process, therefore, starts by stripping out small funds and managers with little traceable experience in the field. To be considered, managers must have at least five years' relevant experience and the controlling parent group must have been in existence for at least three years.
The individual funds themselves must have been running for at least three years and attracted a minimum of US$50m. But in such a flexible and ever-changing environment, these initial filters are not set in stone. Increasingly, a number of new FoHF retail products are adaptations of existing successful institutional products. Where portfolios and strategies are similar, typically a 90% match or higher between the portfolios, the combined total of funds under management may be taken into account to override the $50m limit on individual funds. The decision is taken on a case by case basis, depending on strategies and asset classes.
Even if a fund is under three years old, it may well be eligible for a rating assessment as a 'New Fund' rating. "If the manager has more than three years' experience on a similar fund, we can use this as their personal track record when assessing for a rating," adds Goldsmith.
Having stripped out small and start-up funds, the remaining funds are then assessed by a performance screen using the Sharpe ratio as a gauge of absolute returns for the risk taken. The results of this screen determine if a FoHF qualifies for a more detailed performance assessment and therefore an S&P Fund Rating.
The Sharpe ratio is an industry-recognised measure, which calculates a fund's return over and above a notional 'risk-free' investment, such as cash or Government bonds.
Investors expect funds with a pure absolute return objective to achieve a higher return than the short-term money market rate of their currency denomination. As a first step, FoHFs that have a positive Sharpe ratio over five years (which typically covers a market cycle) are considered for the FoHF ratings process. On the other hand, a negative Sharpe does not mean instant disqualification.
As Goldsmith explains, the Sharpe ratio is not a perfect measure and should be interpreted in context. He says: "Most FoHFs generally focus on absolute returns compared with long-only funds whose objectives tend to be orientated towards beating a benchmark or beating a peer group. However, some FoHFs are influenced by market conditions and market direction, particularly those with a significant weighting in long-short equity or macro."
During the course of the 2000 to 2003 bear market, many FoHFs with a significant allocation to long-short equities, had a strong correlation to stock markets, often giving them a negative Sharpe ratio. Significant exposure to macro strategies, also lead to a degree of market correlation.
In these circumstances where FoHFs prove negative on the Sharpe test, providing their ratios are 'less negative' than corresponding equity indices, they could be considered for the rating process.
Measuring ordinary long-only funds is a relatively simple task, admits Goldsmith, as most funds in each sector are of a similar nature. The same cannot be said about FoHFs, due to the sheer number of asset classes and strategies they cover.
"They are a mixed bunch, there is a commonality in their aim for absolute return consistency, but the methods used are incredibly varied," says Goldsmith.
When it comes to assessing a FoHF for a rating, qualitative research is essential, with an emphasis on the FoHF manager's due diligence process, the assessment of operational risk, the system infrastructure and back-up employed to track the underlying fund managers.
Moreover, because the performance objectives of hedge funds, and in turn FoHFs, are more diverse than for long-only funds, the performance assessment carried out will account for a larger part of the qualitative analysis.
An experienced S&P fund analyst conducts the qualitative review in the form of a face-to-face interview with the manager and team. Interviews can take anything up to four hours and include in-depth analysis of several key areas in addition to those above, such as investment culture, the team's experience and stability, effective use of resources, skill and flair, manager's experience and education, other responsibilities, fund specifics and performance success.
Goldsmith comments: "Once a FoHF has been interviewed and assessed, two Standard & Poor's fund analysts who have been involved in the research present their findings to a wider committee of senior analysts for a rating review."
Standard & Poor's rating scale for FoHFs is the same as that used for traditional long-only funds, assigning A, AA and AAA ratings. For each rated fund, Standard & Poor's publishes a detailed report on www.funds-sp.com covering all the key findings and opinions of the analyst as well as essential information about the fund.
These reports provide investors and advisers with further insight and transparency to FoHFs.
Each FoHF rating applies for one year, with continuous surveillance to catch any changes to management, strategies or individual portfolios. There is a formal, quarterly monitor, published on its website and after 12 months, rated funds are re-assessed, using Standard & Poor's rigorous and tested analysis and interview approach.
The hedge fund world is notoriously secretive and many managers are not well disposed to outside scrutiny. Around 40 to 50 funds have so far been rated and Goldsmith expects the total number of rated funds to continue to grow, but analysts occasionally experience resistance with regards to publishing information.
"There are issues about disclosure," says Goldsmith. "Even though, the FoHF groups recognise the value of ratings and how powerful they can be as marketing tools, at the same time they are sometimes concerned about disclosure of key holdings."
A recent report by S&P Fund Services on FoHFs, available on its website, highlights the issues when compiling even top-10 holdings information, a routine disclosure for the long-only world.
Standard & Poor's qualitative assessment and the resultant FoHF rating ensures that ratings are assigned to FoHFs that demonstrate high standards of quality based on their investment process, risk awareness and consistency of performance relative to its own objectives.
Intermediary reaction has been extremely positive, particularly given the weight of interest in the FoHF world. While long-only losses of the years 2000 to 2003 spurred many investors to look at new alternatives, many waited to see how well the newcomer FoHF stood up as equities recovered.
The S&P FoHF ratings have proved an invaluable tool in helping investors and their advisers make more informed investment decisions.
Standard & Poor's next quarterly in-depth study of FoHFs will be freely available in November on their dedicated funds website www.funds-sp.com.
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