Reading A Hedge Fund Mutual Fund Prospectus Is As Clear As Mud

While more standardization will benefit the hedge fund industry, let’s not throw our cynical lenses out the window.  The SEC filings for Hedge Fund Mutual Funds (HFMF) should not be read through rose-coloured glasses.  Ironically, 1940 Act registration may mystify rather than clarify.  While one would expect greater transparency to illuminate a deeper understanding of the strategy, the standard SEC financial statement structure will make certain matters as clear as mud.    

The transparency of the 1940 Act reporting is a paradox.  HFMFs replicate more sophisticated strategies than traditional long only funds.  Does reading a HFMF Prospectus or Annual Report elucidate what the vehicle is really holding?  To a highly discerning eye, not necessarily. While a typical mutual fund’s constitution is easily comprehensible, for a HFMF this is not so.  The standard, boiler plate SEC financial statements may convolute what the HFMF holdings truly have comprised over the reported period, the amount of leverage used, turnover, valuation, and complicated fee structures.

Window dressing may create false transparency.  The holdings reported reflect those existing on the last day, and only the last day, of the quarter.  For example, a HFMF 2010 Annual Report will likely contain a Schedule of Investments with a disclaimer such as:  “Percentages indicated are based upon investments as of December 31, 2010. The Fund’s composition is subject to change.” This opens up the potential for gaming and trickery.  Many HFMF’s that are subadvised will mirror a “model” hedge fund’s trading strategy, and this is highly confidential.  This increases pressure on the HFMF manager to window dress.  It may be wise to review the fund’s stated turnover rate on Morningstar part and parcel with the holdings to get a sense of the likelihood that heavy quarter end trading is happening.

There are also aspects of a HFMF strategy that the standard financial statements will simply fail to elucidate.  For example, the ability of the long/short hedge fund manager to produce alpha in a down market is a critical measure of her true prowess.  Many long/short managers do not feel confident shorting effectively, so they sell down to cash in bad times.  Conversely, a good shorter loves trading a dislocated market.  It is useful for an analyst to evaluate the manager’s ability to make profit on their shorts.  This distinguishes the long/short managers who can produce alpha which is non-correlated to the benchmark when the market declines. A simple quarterly holdings report will fail to capture this.  When analysing a Long/Short hedge fund in LP form, a good hedge fund analyst knows to procure a history of the fund’s long/short gross and net exposures by month in order to derive the short alpha.  Otherwise, you can’t conclude that the manager is making profitable shorts.  She may have outperformed a bad market just because she made a lucky guess and sold down to cash when volatility increased.  It would behoove a HFMF analyst to drill down into the nuances of a long/short HFMF, but necessary data may not be readily accessible in the traditional mutual fund reports.

The other confounding factor may be frequency of reporting.  Hedge fund strategies are dynamic, and can change rapidly.  Use of leverage and concentrated positions commonly exist.  To base an analysis on only an annual Prospectus, Statement of Additional Information, Semi-Annual and Annual Report creates a window of opportunity for drastic changes to go unobserved.  There may be a need for interim reporting to occur on a monthly or quarterly basis.

In order to allocate capital to HFMF’s in a suitable fashion, structural reform of HFMF filings may be in order.  These changes may entail increasing the frequency or level of detail required to be disclosed.  Our future postings will aim to elucidate other features of HFMF statements that may be engendering false transparency.

Disclaimer

The information contained in this presentation contains confidential information regarding Diamond Oak Capital Advisors, LLC (“Diamond Oak”) and may contain information regarding hedge funds and other investments recommended or otherwise analysed by Diamond Oak.  This document is not an offer to sell, nor the solicitation of an offer to purchase, any interest in Diamond Oak or any hedge funds or other investments discussed herein.  An investment in any hedge fund or other investment discussed herein may be undertaken only through such fund or investment, may be speculative, and may involve a high degree of risk.  An investor in hedge funds could lose all or a substantial amount of his or her investment.

Certain information contained in this presentation has been obtained from sources outside of Diamond Oak and its affiliates. While such information is believed to be reliable for purposes used herein, no representations are made as to the accuracy or completeness thereof and neither Diamond Oak nor its affiliates takes responsibility for such information.  Past, pro forma, hypothetical, projected, or suggested performance of any investment or portfolio of investments is not necessarily indicative of future performance.

This document is neither advice nor a recommendation to enter into any transaction with Diamond Oak or any hedge fund or other investment.  This presentation and its contents are proprietary information of Diamond Oak and may not be reproduced or otherwise disseminated in whole or in part without Diamond Oak’s consent.

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