Hedge funds urged to adopt global standard

The standards were born out of the frustration of pension fund trustee's inability to differentiate between good and bad asset managers in the mid 1980s. Without standards it appeared that all managers were above average performers.

Marketing departments of asset managers would cherry pick good performing accounts, choose particular time periods and self-select return and valuation methodologies to ensure good but non-representative performance.

Globally the standards have been so successful that for traditional asset categories manager presentations are now assumed to be a fair and honest representation of past performance.

GIPS is about to complete its third major re-write. The public comment period ends on the July 1, 2009. While asset managers, country sponsors, consultants, verifiers and software providers are expected to be major contributors, the people for whom the standards are written are likely to be not quite so responsive.

For hedge funds compliance with the standards is beginning to gain momentum. In the US the President's Working Group on financial markets' principles and best practices for hedge funds investors suggested "when practical and applicable, investors should require that hedge fund managers report their performance according to GIPS reporting standards."

The G20's resolve to increase regulation for hedge funds will add further pressure. Although not specifically mentioned, the GIPS standards are exactly the type of unified code of best practice the G20 is looking for.

Past attitudes
In the past there has been the perception that GIPS is not applicable to hedge funds. Currently there are no specific provisions for hedge funds. The core of the standard is the grouping together of portfolios of similar strategies into composites to avoid selection of the better performing accounts, not particularly relevant for hedge funds.

The standards have always been applicable to hedge funds. In the early development of the standards, the GIPS committee decided that the all users of performance information should benefit from fair and honest presentations, including institutional and private clients as well as investors in mutual or other collective funds.

The standards are also intended to cover all asset categories. The GIPS executive committee has established a working group on alternative investment strategies to address issues impacting hedge funds such as side pockets, master-feeder structures, grossing up of performance fees and other issues.

The working group is expected to present its suggestions this year with the aim of ensuring any performance returns presented are truly representative of the underlying performance of the fund.

While it is the company, not an individual hedge fund that must claim compliance to the standards, there is no barrier to single hedge funds being unique members of their own composite. The advantage to investors if a hedge fund is compliant with the standards is the consistency in the application of calculation methodologies and valuation procedures, comparability of performance presentations and a commitment to ethical, representative presentations to all prospective clients.

Valuation propositions
The prospective version of GIPS with an effective January 1, 2011 is expected to require fair valuation of assets within the fund. A hierarchy must be incorporated into the valuation process when determining fair value.

Valuations must use; objective, observable, unadjusted quoted market prices in active markets for identical investments on the measurement date. If not available, then funds must use: objective, observable quoted market prices for similar investments in active markets.

If not available then funds must use quoted prices for identical or similar investments in markets that are not active (markets where there are few transactions for the investment, the prices are not current or price quotations vary substantially over time or market makers).

If these are not available then funds must use market-based inputs other than quoted prices which are observable for the investment.

Subjective, unobservable inputs for the investments where markets are not active at the measurement date should be used if the market-based inputs are not available.

Unobservable inputs should only be used to measure fair value to the extent that observable inputs and prices are not available. These reflect the fund's own assumptions about the assumptions market participants would use in pricing the investment. These must be developed based on the best information available under the circumstances.

Investment companies are also recommended to disclose if investments are valued using subjective unobservable inputs that are material, describe any material change in the valuation as a result of a change in valuation methodology, disclose the key assumptions used to value investments and obtain fair values from a qualified independent external third party.

The consistent application of valuation procedures makes it much more difficult to massage returns and in particular to hide volatility and hence improve risk-adjusted returns.

Investors should require hedge funds to claim compliance with GIPS.

The standards provide additional assurance in the form of independent verification giving an added sense of confidence in the fund's claim of compliance. Verification tests the fund's processes and procedures to ensure they are designed to calculate and present performance results in compliance with the standards.

However, the standards are not designed to identify fraud but do provide an additional barrier to fraudulent companies and in particular ensure the consistent and appropriate application of calculation methodologies and valuation procedures.

The days of rushed, ill prepared due diligence and acceptance of unjustifiable performance fees are over. In future investors will demand transparency, an understanding of the underlying risks of the fund - and, possibly, GIPS compliance and independent verification.