CMRA Books

Hedge Fund Transparency:
Unravelling the Complex and Controversial Debate

by Leslie Rahl, Capital Market Risk Advisors

Hedge Fund Transparency book The only title that focuses solely on hedge fund transparency and offers a balanced perspective that appreciates both the needs of institutional investors and hedge fund managers.

  • Presents clear insight on why hedge fund transparency is an issue, as well as offers solutions
  • Includes "perspectives" based on interviews with numerous eminent practitioners from both sides of the investor/hedge fund debate
  • Service providers including consultants, prime brokers, third party marketers, capital introducers, systems providers, lawyers and accountants, will additionally acquire an enhanced insight into the needs of both investors and hedge funds in order to tailor their services to the market needs
  • The press and the regulators can also achieve enhanced understanding of this complex and controversial subject
  • Written by the best-selling author and practitioner Leslie Rahl, who is the chair of the Investor Risk Committee of the IAFE Committee on Hedge Fund Transparency and is uniquely placed to advise on and explain the issues for all concerned participants


The purpose of this book is to identify, describe and advance the current state of the art as to how and when to measure, manage and disclose hedge fund "risk". Hedge funds are an increasingly popular investment for institutional investors. As institutional investors have begun to embrace hedge funds, their needs - quite different from those of the traditional high net worth hedge fund investors - have triggered a process within some hedge funds of "institutionalisation". An important part of this process has been the increased focus on risk and transparency.

Why do institutional investors want and need transparency?

  • To know if the manager exhibits style drift.
  • To meet a prudent man standard.
  • To understand if the diversification benefits they hope to achieve by investing in alternative assets have been achieved.

But do they really need or want position-level transparency, or is it really risk translucency that they seek?

On the other side of the coin, hedge fund managers have valid apprehensions regarding transparency. The hedge fund manager has efficiency, competitive, and incentive concerns that make increased disclosure policies potentially intrusive and obstructive.

While the road toward increased risk transparency (not necessarily position transparency) for hedge funds is a difficult one and is filled with obstacles, the process is moving forward. This book is an effort to advance this process.

The book is divided into six main sections:

    Section I: Introduction
    Section II: Who invests in hedge funds?
    Section III: Funds of funds
    Section IV: Hedge funds
    Section V: Digging into various hedge fund strategies
    Section VI: Appendices

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Section I consists of six introductory chapters:

Chapter 1 What is Risk? introduces the "galaxy of risks" and offers an historical perspective on the evolution of risk measurement and risk management as well as the language used to describe risk.

Chapter 2 Types of Risk introduces the key risks relevant to hedge fund investing:

  • Market risk.
  • Credit risk.
  • Key person risk.
  • Operational risk.
  • Reputational risk.
  • Iceberg risk.
  • Counterparty risk.
  • Leverage risk.
  • Model risk.
  • Liquidity risk.
  • Liquidity mismatch risk.
  • Sensitivity to assumptions risk.
  • NAV instability risk.
  • Concentration risk.
  • Complexity risk.
  • Borrowing risk.
  • Short-selling risk.
  • Derivatives risk.
  • High watermark risk.
  • Transparency risk.

Chapter 3 Risk Transparency/Translucency introduces the range of risk transparency that currently exists in the hedge fund world from position transparency to risk translucency to opaqueness. This chapter also explores the different perspectives of hedge funds, funds of funds and institutional investors towards transparency and discusses the initiatives under way to bridge the gaps. The chapter also discusses the importance of process transparency and offers useful guidelines on due diligence investigation.

Chapter 4 Risk Measurement traces the evolution of risk measurement techniques and then focuses on value-at-risk (VAR), stress testing and risk budgeting.

Chapter 5 Risk Reporting explains the difference between "data" and "information" and suggests risk reports that will help both hedge fund managers and their investors "visualize" and track the risk in their portfolios.

Chapter 6 Hedge Fund Risk Systems discusses the limitations of commercially available risk management systems for analyzing hedge fund risk and compares some of the current commercial offerings.

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Section II consists of three chapters that focus on hedge fund investing and hedge fund risk from an institutional investor's perspective:

Chapter 7 An Overview of Institutional Investors explores hedge fund investing patterns for institutional investors.

Chapter 8 Plan Sponsors looks at the unique needs of pension plan sponsors including their fiduciary duties and their heightened awareness of "headline risk". This chapter also includes perspectives on transparency from the following distinguished practitioners:

    • William Cook, Aegon USA Investment Management, describes Aegon's "deeds-to-action" audit while concluding that transparency is a "pointless push".
    • Mark Anson, CaIPERS, identifies four types of transparency: disclosure, process, position and exposure transparency and the three primary reasons why investors want transparency.
    • Pierre F. Jette, CDP Capital, discusses risk budgeting and that his company's risk monitoring is currently based on information calculated by the hedge fund manager.
    • Paul Platkin, General Motors Pension Plan, explains that less than 40% of managers give position-level transparency and that on the other hand, everyone gives risk exposure transparency. He also explains that unless you have both liquidity and transparency, transparency alone does not help.
    • Ron Mock, Ontario Teachers Pension Plan, observes that summary risk information may not provide a clear picture of risk or correlation to other funds in the portfolio, and is poor at considering higher moments -an important aspect of risk Without position reporting, he concludes, it can be hard to get a good estimate of return on risk.

Chapter 9 Endowments and Foundations explores the world of hedge fund investing in the world of endowments and foundations. These institutions have been early adopters in the universe of institutional investors as they have the least bureaucratic oversight. There are almost 20 endowments, for example, which invest more than 20% of their assets under management in hedge funds. This chapter also includes perspectives on transparency from the following distinguished practitioners:

    • Jay Yoder, Smith College, indicates that he relies on his fund of fund managers for additional risk management.
    • Matthew Stone, The University of Chicago, states that he really does not see much use in full position disclosure for large endowments, other than to satisfy their curiosity and observe that there is always the question of how much of the information that you receive is actionable. D Mark Yusko, The University of North Carolina Chapel Hill, feels that there is no reason why you should need, or even want, full position disclosure and that this ongoing drive for increased transparency is significantly overblown. He also feels that you just have to put your trust in the due diligence you employed when you selected the manager in the first place.
    • The anonymous Director of Investment Strategies at the endowment of a large university explains that they will not invest unless they get transparency. She feels strongly about getting as much transparency as she can and thinks that there will be segregation in the industry between those who are not transparent and those who are.

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Section III consists of a single chapter addressing the role of funds of funds and the unique risk issues of fund of fund investing.

Chapter 10 What is a Fund of Funds? has its own section in this book because funds of funds play a unique role in the hedge fund/investor interaction. They can fall under the category of investor and, at the same time, they are also a type of fund that investors can select. This dual role provides unique challenges for transparency and risk management. Funds of funds must both:

  1. receive sufficient information from the hedge funds in which they invest to perform the portfolio construction, manager selection, diversification, risk management and due diligence responsibilities that they are expected to perform; and
  2. provide consolidated information to their ultimate investors.

This chapter also includes the perspectives of the following fund of funds managers:

    • Bruce Lipnick, Asset Alliance Corporation, explains how his five-person team monitors all their investments, both direct and indirect and also discusses his belief that the benefits of transparency need to be evaluated depending on the strategy used.
    • Richard Bookbinder, Bookbinder Capital Management, LLC, offers their investors the names of all the managers and feels that greater transparency increases market efficiency and can result in lowering returns.
    • Jack Heidt, Heidt Capital Fund, asks for total transparency, and finds that about three out of four managers they interview are willing to give that.
    • John Trammell, Investor Select Advisors, aggregates risk across the transparent and the opaque funds in which they invest by analyzing the fund's returns and by evaluating interviews with the managers of such funds. About half their underlying funds offer transparency.
    • Kelsey Biggers, K2 Advisors, LLC, explains that some strategies will be better suited to risk transparency than others and to be successful, any transparency standard must provide meaningful, actionable information to an investor across multiple managers, while protecting the position-level exposures of the managers. He suggests that one approach may be to transform hedge fund exposures into risk factors before being aggregated by the investor or a third party.
    • Sean G. McGould, LLC, Lighthouse Partners LLC, demands transparency from all their managers. He feels that transparency allows them to ensure compliance with what the managers have told them they are going to do on a broad level, but cautions that transparency should not be used to fool investors into a false sense of security.
    • Jean Karoubi, LongChamp Group, indicates that 90% of their managers offer the kinds of transparency he needs. He is not interested in seeing positions but is interested in a detailed risk exposure analysis from each of the funds in which he invests. He rates his managers in terms of approximately 18 factor risk categories (each defined by its benchmark.).
    • Jeff Chicoine, Mesirow Alternative Strategies Fund, insists on getting transparency but notes that some managers will not give it. All in all, he uses about 14 different statistical measures and gives out as much information as he can because they are insistent on getting transparency from the hedge funds with which they work.
    • Barry Seeman, AXA, indicates that of the 50 managers they work with, only about four or five do not give them the transparency they want and that the rest give them position-level transparency. He feels that these days, too many people talk about risk management and too few people know what they are talking about.
    • Tom Strauss, Ramius Capital Group, takes risk reports, coupled with extensive on-site due diligence and plugs them into their own proprietary system for grading managers. He ultimately feels that the greatest risk in this business is the underlying manager risk, not the risk inherent in their position.
    • Pierre-Yves Moix and Stefan Scholz, RMF Investment Products, indicate that they do not believe it would be wise to ask for full transparency and that the transparency provided to fund of funds investors should entail full transparency of the fund of funds' decision-making process, useful performance reporting, and may be complemented by the reporting of aggregated risk exposures at the portfolio level.

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Section IV consists of a single chapter, which is an introduction to Hedge Funds.

Chapter 11 An Overview of Hedge Funds is a comparison of the hedge fund strategies across several factors (ie, performance, coverage by major sources, leverage, risk, etc.) that are addressed in Chapters 12 to 20. This chapter also includes perspectives on transparency from the following hedge fund managers:

    • Lee Ainslie, Maverick Capital, indicates that their investors receive quarterly reports that include a detailed review of the past quarter's performance and of current portfolio positioning. His company holds annual investor meetings at which performance and individual positions are reviewed in depth and investors have the opportunity to explore any other topics with the entire investment team. They also do not provide daily position-level transparency as they believe that such disclosure would be harmful to their investors.
    • Andrew Pernambuco, Alexandra Investment Management, indicates that they do not use VAR because it does not apply well to convertible arbitrage and that investors can visit their website and are able to query their positions, allocation of P&L, geographic distribution, real leverage, hedge ration and assets under management (AUM).
    • Michael Rulle, Graham Capital Management, describes how their clients access a GCM website which includes NAV daily, daily VAR, historical VAR, VAR by asset class, and VAR whether long or short. He adds that if their fund investors want transparency beyond what the website offers, they will provide additional information as requested.
    • Myron Scholes, Oak Hill Capital, believes that it is important to provide the fund's risk exposures to the stakeholders. To this end, creditors and investors receive a VAR report on the aggregate portfolio and a breakdown of exposures geographically and by strategy at each month end. They do not provide position-level transparency on their portfolio because they do not think that this listing gives a good picture of the way they think about the risk of the portfolio and its various strategies. O Bill McCauley, III Offshore, indicates that they include stress testing for the worst-case scenario for each summary position and they have over 1,000 different instruments reduced to 30 different strategies. They aggregate everything and show what would happen if everything moved adversely simultaneously. They provide complete transparency and monthly position reports.
    • Mike Linn, Omega Partners, offers a tremendous amount of transparency. They will give what you want upon request. They send out a standard report that includes VAR for normal situations, the maximum capital at risk in extreme situations when the correlation goes to one, Sharpe ratios, and other standard measures.
    • Andrew Weisman, Strativarius Capital Management, offers reports that break down their risk exposure by factors: industry concentrations; geographic concentrations; a breakdown and explanation of the volatility of the portfolio; and their VAR method. They prefer to offer transparency in the form of information rather than offering a book full of positions.

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Section V contains chapters that discuss in detail the most popular hedge fund strategies and their risk factors.

Chapter 12 Convertible Arbitrage
Chapter 13 Emerging Markets
Chapter 14 Long/Short Equity
Chapter 15 Event-Driven (including distressed securities and merger arbitrage)
Chapter 16 Fixed Income
Chapter 17 Global Macro
Chapter 18 Managed Futures
Chapter 19 Market Neutral
Chapter 20 Short Biased

Each of the preceding chapters are outlined in the following manner:

  • A description of the strategy.
  • A list of largest players.
  • A comparison of coverage of funds within strategy by hedge fund data sources.
  • An analysis of indices and their components.
  • An historical performance, by return quartiles, AUM quartiles, source, leverage, Sharpe ratio, etc.
  • An identification of the key risks of the strategy.
  • A discussion of the applicability of VAR to the strategy.
  • A list of key due diligence questions for funds in the strategy.
  • A brief description of publicly disclosed problems that have affected the strategy.

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Section VI contains eight appendices.

    Appendix 1:

    Hedge Fund Disclosure for Institutional Investors, findings of the Investor Risk Committee (IRC) on hedge fund risk transparency.

    Appendix 2:

    Sound Practices for Hedge Fund Managers, released by Caxton Corporation, Kingdon Capital Management, LLC, Moore Capital Management, Inc., Soros Fund Management, LLC and Tudor Investment Corporation.

    Appendix 3:

    Due Diligence by Jon Lukomnik of Capital Market Risk Advisors, Inc. (CMRA) from A Guide to Fund of Hedge Funds Management and Investment published by the Alternative Investment Management Association Limited (AIMA), October 2002.

    Appendix 4:

    Questionnaire for Due Diligence Review of Hedge Fund Managers, a CMRA-enhanced version of the AIMA due diligence review guidelines for hedge fund managers that is expanded to include a more extensive risk focus.

    Appendix 5:

    Risk Standards for Institutional Investment Managers and lnstitutional Investors, prepared the Risk Standards Working Group (comprised of eleven plan sponsors) with technical assistance from CMRA.

    Appendix 6:

    Buy-Side Risk System Comparison Matrix, a detailed comparison of proprietary buy-side risk systems.

    Appendix 7:


    Appendix 8:


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Book Reviews


Risk Magazine's Review of Hedge Fund Transparency:
Unraveling the Complex and Controversial Debate
By Leslie Rahl
Risk Books
hardback, 700 pages
IBSN 1-904-33904-2

A clear winner

The recent turbulence in global stock markets means this book couldn't have come at a better time. Each article does an excellent job of explaining why hedge fund transparency has become such an important issue for investors who are seeking better ways to measure and minimize hedge fund task. This book aims to address all the questions about transparency and the types of risk related to hedge fund investing.

Leslie Rahl presents in great detail the key components of a risk management framework. The first section compares the different components of risk management and risk measurement. Market, operational and credit risk are examined, with a particular focus on liquidity risk, including a few examples and an Introduction to the due diligence process.

Next, the author discusses how an institutional investor should approach hedge fund investing today, and handle the issue of risk transparency. Investors must request full position details from hedge funds, perform ongoing risk monitoring and due diligence, and carefully examine strategy drift. This is especially true for funds of funds (FOFs), where managers are actively managing the underlying hedge funds.

How a FOF manager conducts asset allocation to various strategies under different economic conditions should be of grave concern to investors. Results of recent surveys on hedge fund transparency are displayed in tables and graphs, showing investor and manager views of desired types of transparency. An important innovation for this book is that it shows the types of positions hedge funds disclose to investors.

The evolution of risk rneasurement over the past three decades is juxtaposed with discussion on value-at-risk, stress testing, risk budgeting and risk-adjusted performance measurement. Using a 'single number', or even a single method, to measure risk may be detrimental to the investor, so the articles discuss the pros and cons of three methods for calculating VAR and highlights some pitfalls of VAR. A handful of stress tests can also be an indispensable tool in a risk arsenal. Multiple scenarios during past extreme market events are analyzed

Next, the importance of risk budgeting and risk-adjusted returns management is discussed. A well-known firm presents a list of topics that a risk profile should address. Stress testing VAR types by region, strategy, volatility, spread and directional stress of hedge funds is also observed. As noted, a majority of risk indicators are 'backward-looking' measures, and several risk reports do not offer concrete conclusions. Risk reporting is discussed and the differences between data and information are outlined.

The second section identifies groups with an interest in hedge fund investment, accompanied by breakdowns by region and strategy. Investors can examine the most current research by top hedge fund consulting firms about what areas are being invested in. Several detailed graphs and charts identify past, present and future trends by examining various risk management standards and transparency issues. A chapter on plan sponsors has interviews with well-known pension fund managers and a partial list of pension funds investing in hedge funds. Next is a detailed display of endowment and foundation assets, as well as their percentage allocation and a list of the top 25 endowment funds investing in hedge funds.


The third section explains the advantages of diversifying a traditional stock and bond portfolio with funds of hedge funds. The entire section is devoted to FOFs, with illustrative examples from a dozen FOF managers. Because of their unique nature, FOFs have a twofold role to play in terms of transparency and risk management. FOF manager's must conduct proper tests and due diligence for manager selection, risk management, portfolio construction and diversification, and be sure to relay the results to potential investors. This section takes readers through the selection process for hedge funds of several reputable FOF managers - an invaluable resource for investors.

The pros and cons of investing in FOFs versus individual hedge funds is also covered. The rankings and volatility of FOFs with more than $1 billion in assets is displayed, as well as rankings using the Shape ratio and correlations versus the S&P 500 index. Finally, the question of how many funds should be used to construct an optimal FOF is discussed, as well as the performance of FOFs in down markets. Survivorship and selection bias are observed and compared with various FOF indexes, and a recent survey of FOFs is presented.

The fourth section looks at the growth of the hedge fund industry, the number of funds, assets under management, the most popular styles, risk and exposure characteristics of strategies, leverage used, volatility comparison between styles, performance of various classifications, correlation against various markets, and analysis of VAR by style and extreme market events. The various FOF indexes are then compared, and there is a brief look at the 25 largest hedge funds. Interviews are also conducted with leading hedge fund managers, and there is an outlook of the future of the industry.

The last section discusses each hedge fund strategy in great depth and examines the risk factors and largest players in each strategy by examining performance, leverage and risk-adjusted measures coupled with due diligence questions for each strategy. A new twist in this book is the publicly disclosed problems for funds in each strategy A total of eight appendices provide a wealth of supplementary information, such as questionnaires for due diligence, review guidelines, and risk standards for hedge fund managers and investors.

This exceptional book is a must for pension fund managers, endowments, institutional investors, brokers, financial planners, lawyers and anyone wishing to learn more about this fascinating industry.

Greg Gregoriou
University of Quebec at Montreal
and Hedge Fund Analytics of Montreal

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