Hedge funds have faced headwinds in recent years. One problem may have been self-induced: funds don't give investors a consistent way to measure how much money they make.

There’s no consistency in how the $3.2 trillion hedge fund sector spells out its results, hampering the sector from growing more than it otherwise would, a report says. Agecroft Partners recently told members of the CFA Institute that there’s no consistency in how net performance (taking account of fees) is set, and later spelled out to investors.

“The most important issue that needs to be addressed is standardizing how to calculate and present a hedge fund’s net performance. One might suggest simply subtracting all fees and expenses from gross returns. Unfortunately, most things are not as simple as they first appear,” the firm, a consulting and third-party marketing firm in the alternative investments space, said.

Agecroft gave the example of when a fund is launched with non-fee-paying partner capital. After two years of managing internal capital only, managers add external capital to the fund. With some funds, the net performance of the fund is shown, but that overstates the manager’s skill level, because there were no fees charged for the first two years - inflating the net return. The average fee charged in later years will continue to be below the stated fees due to the non-fee-paying assets of the fund. (Other managers calculate performance assuming that all assets in the fund paid full management and performance fees from day one.) The firm said that the difference between these two approaches, assuming a 10 per cent gross return and 1.5 per cent management fee with a 20 per cent performance fee, is more than 3 per cent annualized during the first two years of the fund. 

“This difference in performance is unacceptably misleading. While past performance does not guarantee the future, this data is an important part of the fund selection process,” the report continued. It identified other practices which it said make comparisons hard to achieve.

Although the global hedge fund sector has been through difficult periods after the 2008 financial crisis, and fees have come under pressure, the sector is still one of the most important alternative asset class categories. Family offices, institutions, some HNW individuals and professional investors use them across a range of strategies. Recently performance has been robust. According to Hedge Fund Research, the Chicago-based group tracking the sector, its HFRI Fund Weighted Composite Index® - a wide measure of returns - gained +5.7 per cent in the first three months of this year, the strongest first quarter gain since 2006.

Setting the standard
With fees being an ever-present issue for investors, particularly when returns are mixed, inconsistent performance measures must be tackled, Agecroft said. 

“The industry standard should be that hedge fund net performance reflects the current highest available fee schedule and assumes it is paid on all assets in the fund since its inception. If fees are raised or lowered, historical performance should be restated to reflect net performance since inception based on the currently available fees. The one exception would be if the change in fees coincided with a major change in how the fund was managed,” it said.

The firm said when disclosing performance, funds should set out how valuations are determined and whether these are checked by a third party. Disclosures should also show how liquid underlying investments are.

Funds should also explain how the growth of assets under management can hit performance over time, the organisation added.

(Editor’s view: The arguments about consistent measurements of returns are well made. Other alternative asset class areas such as venture capital, private equity, private debt, real estate and infrastructure arguably suffer from similar problems, particularly when a fund starts with no external capital (and hence fees) and then starts to take in external money. Do investors fully understand how “internal rate of return" (IRR) works and what it means? There appears to be an education task for advisors here. Complete consistency may never be possible and it is not necessarily a bad thing if there are different ways to measure performance, but demands for standardization are bound to come as more and more money enters into these fields. This is also something for regulators to consider.)