09 April 2012

VoxEU: Are voluntary hedge fund disclosures reliable?

In the wake of the financial crisis, SEC proposed a rule requiring US-based hedge funds to provide regular reports on their performance, trading positions and counterparties. Before the policy is phased in, this column argues that such a move will benefit not only regulators but investors as well.

Despite the miles of column inches devoted to the hedge fund industry in the financial and popular press, relatively little is known about their trading strategies, risk profiles, liquidity needs, or potential for impact on systemic risk. In the wake of the recent financial crisis, the Securities and Exchange Commission proposed a rule requiring US-based hedge funds to provide regular reports on their performance, trading positions, and counterparties to a new financial stability panel established under the Dodd-Frank Act. A modified version of this proposal will be phased in starting late this year, and requires detailed quarterly reports for 200 or so large hedge funds (those managing over $1.5 billion) and less detailed, annual, reports for smaller hedge funds. The proposal makes clear that these reports would only be available to the regulator, with no provisions in the proposal regarding reporting to funds' investors. Nevertheless, hedge funds argued against the proposal, concerned that the regulator collecting the reports could not guarantee that they would not eventually be made public.

One significant disclosure that hedge funds offer to a wider audience is reports of their monthly investment performance. This self-reported information is provided by thousands of individual hedge funds to one or more publicly available databases, which are widely used by researchers, current and prospective investors, and the media. As SEC rules preclude advertising by hedge funds, these performance disclosures (as well as disclosures on fund size and a few other fund characteristics) are considered to be one of the few ways that hedge funds market themselves to potential new investors.

Recent policy debates on the pros and cons of imposing stricter reporting requirements on hedge funds have raised various arguments. The benefits of disclosures include market regulators having a better view on systemic risks in financial markets, and investors and regulators being able to determine better the true, risk-adjusted performance of funds. Costs include the administrative burden of preparing such reports, and the risk of leakage of valuable proprietary information on trading strategies that may be backed out from portfolio holdings. The analysis by authors Andrew Patton, Tarun Ramadorai and Michael Streatfield suggests that mandatory, audited disclosures by hedge funds, such as those proposed by the SEC last year and due to be implemented in 2012, would be beneficial to regulators. Their analysis additionally suggests that it would be worth considering whether these reporting guidelines, which currently only apply to funds' disclosures to regulators, could also apply to disclosures to prospective and current investors. Their analysis suggests that such information would help hedge fund investors make more informed investment decisions.

Full paper

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