Financial Education

A previous article noted that hedge funds tend to be fairly secretive, and discussed some of the reasons for that.  However, both investor pressure and the threat of regulation have led hedge funds to be somewhat more transparent over time, even if only selectively so.

One way for funds to be more transparent is to disclose risk factors rather than specific positions. Thus, the hedge fund could say they have exposure to equities, interest rates, volatility, or other factors without noting specific positions. Investors are able to learn important information about their investments, including what types of risk they may need to diversify or hedge, but competitors do not get information they could use to either piggy-back or front-run the hedge fund.

A target rate of return that is not based on market returns. It could be a specific return, such as 10%, as opposed to exceeding the return on the S&P 500.

Hedge funds can choose to report their results to database providers who report the overall performance of hedge funds in various categories.

Since performance disclosure is voluntary, peer performance is not a reliable measure. Poor performing managers are not likely to disclose performance (biasing performance upward) and large established managers may not want the trouble (or may want to make their performance stand out rather than be averaged into the peer group.) The aggregate effect is probably that database returns are overstated.

Hedge funds are sometimes criticized as lacking transparency. There are a number of reasons for this.

For one thing, they are privately organized entities with minimal regulatory oversight. They are not required to disclose their holdings and strategies, so they do not.

Closely related to the lack of regulation is the fact that they are only marketed to qualified investors – those who presumably have both the sophistication to understand the strategies and the capacity to accept losses. These qualified investors may be able to glean information about the fund, but public investors, who are not able to invest in the fund anyway, are not.

Perhaps the most significant reason, however, is competitive secrecy. Hedge funds are competing both for investment funds and for investment opportunities. They often employ sophisticated techniques that could be compromised if they were widely known.

Hedge funds are not subject to investment restrictions and thus have greater breadth of investment instruments at their disposal. These typically include leverage, short sales, derivatives, and concentrated or illiquid positions.

The N-firm concentration ratio is an intuitive measure of industry concentration. Industries with high (or low) levels of concentration have few (or many) competitors.

The N-firm concentration ratio is found simply by adding the market shares of the N largest firms in the industry. For example, in an industry with six competitors with respective market shares of 30%, 20%, 20%, 10%, 10% and 10% the three firm concentration ratio would be 30% + 20% + 20% = 70% and the 5-firm concentration ratio would be 90%.

The N-firm concentration ratio is an intuitive measure, but the Herfindahl index provides a greater degree of discrimination. As a result, when the two indicators offer differing signals the Herfindahl index is likely more reliable.

The Herfindahl index is a measure of how concentrated an industry is. An industry with few competitors will have a high level of concentration, while many competitors results in low concentration.

The Herfindahl index measures concentration as the sum of the squared market share of each firm in the industry. For example, consider an industry with six competitors, with respective market share of 30%, 20%, 20%, 10%, 10% and 10% the Herfindahl index will be (0.3*0.3) + (0.2*0.2) + (0.2*0.2) + (0.1*0.1) + (0.1*0.1) + (0.1*0.1) = 0.09 + 0.04 + 0.04 + 0.01+0.01 + 0.01 = 0.2.

As a general rule, a Herfindahl index below 0.1 signals low concentration, while a Herfindahl index above 0.18 signals high concentration. Between 0.1 and 0.18 the industry is moderately concentrated.

If all firms in an industry have equal market share, the reciprocal of the Herfindahl index (1/H) will equal the number of firms in the industry. For industry in which firms have unequal share, the reciprocal of the Herfindahl indicates the “equivalent” number of firms. In this example, the six firms in the industry have the same level of concentration as an industry with 1/0.2 = 5 competitors with equal market share.

Compared to the N-firm concentration ratio, the Herfindahl index offers greater discrimination as it includes all firms in the industry and weights the firms according to market share. However, it is not a particularly intuitive measure.

Many portfolio analysts use different sets of variables for portfolio return and risk attribution, respectively. As risk and return tend to be intimately linked, this practice can obscure the relationship between the two. In the March/April 2008 Financial Analysts Journal Menchero and Poduri demonstrate how to align return attribution and risk attribution into a general framework.

Active return, tracking error and the information ratio are attributed to a user-defined set of factors reflective of the manager’s decision-making process. The attribution can be applied on either an ex ante or an ex post basis.

Outside investors and analysts do not typically have access to a company’s general ledger or journal entries. As a result, they must use the financial statements that result from the accounting process to infer the transactions that took place.

Since preparing financial statements requires considerable judgment and can even be subject to misrepresentation, analysts must also assess whether the judgment involved seems reasonable. Often this can be done by comparing the various accounts that might be affected by a given transaction.

For example, if a company were to record fictitious revenue there would be no cash inflow as a result. Instead, the revenue would likely be offset by an account receivable entry. By comparing the trends in sales and accounts receivable the analyst can potentially identify questionable results.

The concept of Value at Risk (VaR) has a number of practical advantages and disadvantages.

Advantages are that it:

• quantifies potential losses in simple terms (a 5% chance of a loss exceeding $1 million)
• has met with approval from various regulatory bodies concerned with the risks faced by financial institutions
• is versatile

Limitations include:

• estimation difficulties, and sensitivity to estimation methods used
• potential to create a false sense of security
• tends to underestimate worst-case outcomes
• the VaR of a specific position doesn’t always translate well into the VaR of the overall portfolio
• it fails to incorporate positive outcomes, thus painting an incomplete picture