S&P in bid for FOHF transparency

Standard & Poor's Fund Services is to expand its fund of hedge funds rating process to include in-depth leverage analysis in the light of the rampant degearing in the sector.

Randal Goldsmith, lead analyst, said the ratings agency would pay more attention to how funds of hedge funds managed their borrowings after the chaos in the banking system at the end of last year caused many credit lines to be withdrawn.

"We were a little bit surprised by the way redemptions took off in October," he said. "It wasn't completely apparent to us that some of the credit lines wouldn't prove solid.

"It will make sense to ask more questions in relation to credit lines in the future. We wouldn't like to see a return to a situation where funds of hedge funds rely heavily on them."

Mr Goldsmith said S&P would ask fund managers which banks they used and for details of their credit line terms.

"If the manager does not give us the transparency, we will mark them down," he said.

But he added S&P would highlight the leverage policy of the funds of hedge funds it rated rather than limiting it.

The analyst also criticised funds of hedge funds' liquidity management. In his own words, fund of hedge funds managers had told him, "We don't need cash as part of our asset allocation view because we have hedge fund managers in the portfolio who make that asset allocation call. We don't need cash to protect us in the light of sudden redemption requests."

As Mr Goldsmith observed: "That has proved false. It's far better to maintain a modest amount of cash. After the liquidity problems of last year, investors may not be very forgiving of those funds that suspended redemptions or applied gates."

S&P's performance analysis has also changed as a result of the crisis. Normally, Mr Goldsmith said S&P would look for a positive Sharpe ratio over five years - or an outperformance of the risk-free rate over that period - as a qualifying feature for a fund of hedge funds.

But according to Mr Goldsmith, the chaos of 2008 has meant a significant proportion of the funds of hedge funds S&P rates now have a negative five-year Sharpe ratio.

"Outperforming by losing less money, no matter how significant the difference is, is not quite the same as outperforming with a positive return," he said.

Despite S&P's recent review of its fund ratings process, Mr Goldsmith said it would not extend its analysis to include fund of hedge funds' underlying hedge fund holdings.

Although some of the portfolios S&P rates had invested in portfolios run by Bernard Madoff, the analyst said his division had not hired an operational risk manager who would be able to analyse a hedge fund.

He observed S&P's stated task had been to analyse funds of hedge funds and the resources and track records supporting them, rather than perform due diligence on their investments.