Among the ifs and shoulds and might-have-beens haunting investors who have lost money in hedge funds lately is the one about ratings. What if there had been a comprehensive and broadly reliable system or two that tracked the world’s thousands of hedge funds and graded them, with points or stars, thumbs up or down, based on which managers were overleveraged, which practiced poor risk management, which were merely trying to mimic successful strategies rather than create them?
Clearly, there is interest in the idea. When Moody’s Investors Service started rating hedge funds in 2006, the industry was in ascent and drawing hordes of investors who wanted to know which funds to invest in and — equally important — which ones to avoid. Moody’s was glad to begin offering customers what they sought, and started conducting operational reviews of hedge funds, getting into background checks, liquidity and risk management.
“Investors want to know about a fund’s internal behavior — Does the fund create a culture of risk? Does it take the appropriate processes to mitigate risk?” explains Brian Johnson, vice president of business development for Moody’s alternative investments group. Johnson notes that institutional investors are particularly fastidious: “Consistency, continuity, accountability — these factors are very important to institutions.”
But parsing the operational strengths and investment acuity of hedge funds is an inherently difficult task because they are not models of transparency. Two years after rolling out its first hedge fund ratings, Moody’s has evaluated just 21 funds.
Although the industry is struggling as investors run for the exits, the demand for ratings is far from dead. Chicago-based Morningstar, well known for its one- to five-star ratings on mutual funds, in February 2008 introduced star ratings based on risk-adjusted performance measures for about 2,000 single-strategy hedge funds and in October began doing the same for some 1,000 funds of hedge funds. “There’s a clamoring: ‘Where are your fund-of-funds ratings?’” says John Rekenthaler, Morningstar’s vice president of research and new product development.
From the investors’ side of the equation, then, ratings are perhaps as much in demand as ever. The other, smaller end of the market, in which hedge funds themselves arrange for ratings to confirm the quality of their debt, has faded with this year’s collapse of equities and freezing up of credit markets. This part of the ratings game — controlled largely by New York–based firms Fitch Ratings, Moody’s and Standard & Poor’s — has faltered along with the economy. “It’s fairly dead, and it will be a long time before hedge funds come back for ratings again,” concedes Eileen Fahey, a managing director of Fitch’s financial institutions group.
“The environment is very tough right now,” agrees John Hagarty, chief operating officer of FrontPoint Partners, a Greenwich, Connecticut–based hedge fund firm. “While I wouldn’t say we are uninterested in ratings, it is definitely not in our top priorities at this time.”
Part of the push early this decade for ratings came from hedge funds seeking third-party affirmation for their operations in order to attract investors and underwriters. Skeptics questioned how plausible it was for Moody’s, S&P and Fitch to issue informed opinions on hedge funds, which are typically much less transparent than the corporate and public debt and structured-finance deals the firms are better known for rating.
“It’s not clear how successful they are at evaluating the kind of complex and heterogeneous risks that hedge funds contain,” says Andrew Lo, the well-known MIT Sloan School of Management–based scholar and hedge fund manager. Lo says that although it makes sense intuitively for there to be a hedge fund rating system and that such a system could be tremendously useful (especially to institutional investors, which have fiduciary obligations to invest prudently), rating firms still lack the deep analytical tools to pull it off. “It will be some time before they gain the kind of acceptance that debt ratings have achieved,” he notes.
Other skeptics, such as Greg Friedman, chief investment officer of Pittsburgh-based investment consulting firm Greycourt & Co., argue that any hedge fund rating should be viewed circumspectly because it will be only as good as the analyst behind it and the analyst might not be well informed in the first place. If he or she knows so much about hedge funds, Friedman asks, “why in the world would they be working for a rating agency?”
In an effort to assess the hedge-fund-fueled end of the markets, Fitch in March gave BBB+ ratings to Citadel Kensington Global Strategies and Citadel Wellington, the two biggest funds run by Chicago-based Citadel Investment Group. (In October, Fitch lowered the rating to BBB and the outlook from “stable” to “negative.”) In cooperating on ratings, Citadel — which is very much the exception among hedge fund firms in this regard but is suffering as much, or more than, many in 2008, down by 47 percent through November — hoped to lessen its dependence on prime brokers by attracting a separate stream of financing. A respectable rating shows that a fund has the wherewithal to repay debt and is free of the need for prime brokers’ capital, making it especially attractive these days, as brokerages themselves grow increasingly shaky.
Jacqueline Meziani, director of S&P’s financial institutions ratings, argues that although ratings are helpful to investors, they can also be valuable to hedge funds. “It’s worth the scrutiny to discover even negative credit factors because it can be illuminating,” she says. “It provides feedback from an objective third party.”
S&P, which rates 16 alternative-investment funds, has a small ratings team with standard credit-analysis experience augmented by people who have worked for hedge funds, Meziani notes. “The analysis is intense,” she says.
Though well-known, industry-comprehensive and widely accepted ratings will probably remain elusive until hedge funds become less opaque, there remains a well-funded third-party demand for such knowledge, argues Joseph Omansky, founder of Sky Fund. His small Princeton, New Jersey–based company’s SkyRank System tracks 4,310 hedge funds and 3,648 funds of funds and issues ratings on about 85 percent of them. The system is entirely quantitative, Omansky says, taking into account cash under management, leverage, volatility and historical returns, among other things. SkyRank’s ratings range from A+, the top end of the spectrum, to E at the bottom. Worth noting is that as of the end of October, SkyRank gave 37 percent of the hedge funds it rates an E, up from 6 percent a year earlier. That is “due to the credit crisis, deleveraging and forced liquidation,” he reports.
The value of a system like SkyRank, Omansky asserts, is in what he says is its unique level of purity. “Getting paid by companies to rate their firms, whether in bond, stock or hedge fund ratings, is not a viable model, as it represents a deep conflict of interest,” he argues, noting that SkyRank is subscriber-based.
Still, the hurdles that confront sound ratings persist. Hedge fund managers, administrators and investors point to the variety, complexity and secrecy of hedge funds, observing that strategies employed in one fund’s environment may not work in another’s. “They are difficult to encapsulate with a single analytical data point,” notes Kenneth Heinz, president of Chicago’s Hedge Fund Research. “There’s no cookie-cutter formula.” (HFR tracks assets and performance but doesn’t compile ratings.)
Rachel Minard, president of Cogo Wolf Asset Management, a San Francisco–based fund of hedge funds with almost $100 million under management, says it’s tough to do an apples-to-apples comparison between funds and that any concerted effort to do so could lead to a commoditizing of the industry. “There are so many nuances, so much distinctiveness — it’s the idiosyncrasies that make each fund what it is,” says Minard, a former global marketing director at Corbin Capital Partners, the funds-of-funds arm of New York–based Dubin and Swieca Asset Management. “Do we really want to take a mutual fund approach?”
Maybe not, but the big rating agencies themselves are under fire for failing to properly assess the sprawling mortgage-security risk that led to the credit market meltdown. The major criticism of the industry is its built-in conflict of interest: Rating agencies are often compensated by the firms whose investment offerings they rate, a model that may prevent analysts from putting investors’ interests first. But shifting the paradigm to one in which investors pay the agencies would create other distortions, some analysts argue, perhaps by giving preferential treatment to bigger and wealthier investors.
The credit rating industry hasn’t given up on trying to establish a more substantial hedge-fund-rating sector, however, in large part because institutional investors continue to request ratings that gauge the quality of management, notes Moody’s vice president Johnson.
“They want us to assess risk and the fund’s core competency,” he says. “We think the market has warmed up to our operational quality ratings and will even more so in this environment.”
Much of the push for broader acceptance is rooted in a kind of soft sell that comes with the caveat that ratings should never be the be-all and end-all and that investors are responsible for whatever decisions they make. “It’s wrong to rely solely on single or multiple ratings,” agrees Christopher Kundro, co-CEO of New York–based LaCrosse Global Fund Services, an investment consulting firm, though he says they can be an important part of an investor’s tool kit.
Morningstar’s Rekenthaler says the value may be largely in the warning signs ratings can offer: “Investors are looking at the rating to prevent danger, fraud and to weed out funds that are not equipped to handle growth,” he explains.
But any rating should be backed up by additional homework. “It should just be seen as an input to the due-diligence process,” says Johnson.
