Morningstar Advisor - Spring 2007 - 36

Hands-On Know Your Data: Beware These Caveats When conducting any kind of research on hedge funds, you should be aware of the following: There is no industry standard for calculating hedge fund NAVs or returns Hedge fund returns are not normally distributed As such, all calculations using standard deviation, including Sharpe ratio, Sortino ratio, correlation, and beta will not be accurate. Use them only as estimates. Also consider skew and kurtosis, which may be a sign of large tail risk whose returns significantly exceed its peers during a specific time period, inquire as to the amount of leverage used. Not all hedge funds are “absolute return” If you are comparing the returns of two funds, you may not be comparing apples to apples. Alpha, beta, correlation, and volatility change over time If the fund exhibits high kurtosis and negative skew, inquire more deeply about the fund’s strategy. Specifically, do the fund’s investments act like short out-of-the-money options, with a small upside and a large, infrequent downside? Leverage is an infrequently reported data point Many use directional strategies and, therefore, will have significant correlation to the broad markets. What’s more important is the fund’s correlation to your client’s portfolio. In Advisor Workstation, you can add a hedge fund to your client’s portfolio and look at the correlations between current holdings and the hedge fund. Concentrate especially on the fund’s performance during periods of market strife. K Simply selecting a different time period can skew data in favor of or against a claim. Hedge fund beta is specific to the hedge fund strategy and investment process A simple linear regression will not adequately capture hedge fund beta. Incorrect measures of beta lead to incorrect measures of alpha. If reported, you can view a fund’s leverage ratio in a custom data point view. If not reported, it’s prudent to inquire as to the fund’s leverage ratio and how it is calculated. Leverage can include margin borrowing, other bank loans, and inherent leverage from derivatives, such as options and futures. When considering a fund Nadia Van Dalen is a hedge fund analyst for Morningstar. SEC Steps Up Effort to Oversee Hedge Funds Seventy percent of 600 advisors surveyed last year by Morningstar and Research magazine said that hedge fund registration, whether required or voluntary, is a positive development. The SEC would agree, although it’s having mixed results in its efforts to increase oversight of the hedge-fund industry. Here’s a rundown of recent major developments. In 2004, the SEC passed a rule that required hedge funds to register with the SEC under the Investment Advisers Act of 1940 if they had more than $20 million in assets and more than 15 clients. Registering would require hedge funds to disclose more information about themselves to regulators. In June 2006, the U.S. Court of Appeals for the District of Columbia struck down the rule, and hedge funds are not required to register. The SEC chose not to appeal the ruling. However, about 2,500 of the more than 8,000 hedge funds in existence are registered with the SEC. In December 2006, the SEC proposed to amend the definition of an “accredited investor.” The current rule is that the investors must have a net worth of at least $1 million or have an annual income of more than $200,000 (or $300,000 in joint income) to qualify. The new rule would add a requirement that investors must own at least $2.5 million in “liquid” investment assets (which excludes real estate not held for investment purposes, such as a primary residence). If the new rule goes into effect, according to the SEC, the percentage of U.S. households that would be eligible to invest in hedge funds would drop to 1.3% from 8.5%. As we went to press, the proposal was in its public comment period. 36 Morningstar Advisor Spring 2007

Morningstar Advisor - Spring 2007

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