New Era in Hedge Fund Transparency?

Just as President Barack Obama is expected to call for a new era of responsibility and accountability in America at his inauguration today, hedge funds and fund-of-funds are going to be asked to do the same.In the wake of investor losses from the Madoff scandal, it's expected that institutional investors, endowments and charitable foundations will demand more disclosures from fund-of-funds. And regulators such as Mary Schapiro, President Obama's nominee to head the Securities and Exchange Commission (SEC), indicated she plans to impose more oversight on hedge funds to bring more transparency and accountability to the financial markets.

Some fund-of-funds that invested in financier's Bernard Madoff's alleged Ponzi scheme didn't even tell investors that these FOFs were investing in Madoff's strategies. The Ascot Fund Ltd. run by New York financier Ezra Merkin and Fairfield Sentry Ltd., reportedly allocated all of their assets to Madoff but didn't disclose that to investors. They were part of an international network of feeder funds that fueled Madoff's alleged Ponzi scheme with the ability to pay out older investors with continuous inflows coming from new investors.

According to Michael Griffin, executive vice chairman at Chicago-based Spectrum Global Fund Administration, institutions will demand more transparency and frequency of reporting from hedge funds. Griffin was formerly the COO of Fenchurch Capital Management, a fixed-income arbitrage hedge fund that was highly leveraged. To answer investors' concerns, Fenchurch provided "fully loaded NAVs (net asset values) on a daily basis, " said Griffin, noting that the hedge fund looked more like a mutual fund in terms of what it was reporting to clients. (He closed Fenchurch in 1998 and opened Spectrum in 2000 to provide middle and back office outsourcing as well as fund administration services to hedge funds and fund-of-funds.) While the standard for reporting hedge fund net asset values is monthly, Griffin thinks it could go to weekly or even daily.

For example, a hedge fund generates a net asset value at the end of the month and so a fund-of-fund will typically have to wait until the hedge fund closes its books.

The issue is whether the technology of the fund-of-funds can support that, he said. For example, Spectrum is collecting the data from the underlying hedge funds. "It really depends on the relationships that the FOF has with the underlying hedge funds and what the hedge funds is able to provide," said Griffin.

On the other hand, "hedge funds don't want to give out much proprietary data because they don't want the market trading against them," he said.

Even with their secrecy and control over information dissemination, hedge funds had a tough year in 2008. The New York Times on Sunday reported that Kenneth Griffin, head of Citadel Investment Group, saw the value of his hedge fund assets plunge by $10 billion last year. In a story, "Hedge Funds, Unhinged," the NYT interviewed Griffin about the rough patch his firm experienced in the third and fourth quarters of 2008. Griffin is known as a whiz kid that traded convertible bonds from his dorm room at Harvard University, the story noted. But last year he made some heavy bets on convertible bonds as well as the spread between credit-default swaps and corporate bonds, which went against him. At one point, Griffins' funds were down 55 percent, while the average hedge fund was down 18 percent, the New York Times reported.

Meanwhile, fund-of-funds had the largest capital reductions. "The fund-of-funds asset flows have declined," said Kenneth Heinz, president of Hedge Fund Research in Chicago. The total capital in fund-of-funds peaked in the end of the second quarter at just over $825 billion and declined to $685 billion at the end of October, which reflects redemptions of $13 billion and $22 billion in the month of October, he said. HFR's research shows that 693 hedge funds in total (including FOFs) were liquidated in 2008 though the end of October vs. 603 that were launched over the same period.

Assets under management in the global hedge fund industry declined to $1.56 trillion at the end of October, a level last seen at the end of Q4 2006, according to HFR.

"I think there's going to be a whole sea change in the way that investments are going to be looked at in the alternative space, and the success or level of transparency will depend on the hunger for capital," said Griffin. If hedge funds are in more need of capital from investors, they may no longer be able to operate in secrecy and may have to acquiesce to investor demands for more transparency.If hedge funds are in more need of capital from investors, they may no longer be able to operate in secrecy and may have to acquiesce to investor demands for more transparency. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio