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Market turbulence focuses attention on S&P fund of hedge funds ratings

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The summer’s turbulence in the credit and mortgage-backed securities markets and its knock-on effects on the hedge funds that invest in them has helped to focus attention on the role of ra

The summer’s turbulence in the credit and mortgage-backed securities markets and its knock-on effects on the hedge funds that invest in them has helped to focus attention on the role of ratings, as institutions and other investors seek more expert sources of information to assist their investment decision-making processes.

In July investors withdrew USD55bn from funds of hedge funds, an estimated 5 per cent of the sector’s total assets under management, according to the TrimTabs BarclayHedge Fund report, and there are fears that redemptions for August may prove to have been even bigger once full figures are available early next month.

With close attention being paid to the ability of fund of hedge funds managers to pick underlying funds that continue to prosper in more volatile market conditions, investors are increasingly examining the processes used by fund of funds managers and the capabilities of their operational structures as well as their investment skills.

The extension of Standard & Poor’s fund management ratings to the fund of hedge funds sector reflects the growing demand worldwide for alternative products among a wider range of investors, the increasing use of funds of funds to reduce the risk of hedge fund investment through diversification, and moves by national regulators to permit the sale of funds of hedge fund products to retail investors.

Standard & Poor’s Fund of Hedge Funds Ratings draw on the global reputation of the fund management rating process but reflect the different characteristics of the funds. For example, S&P does not evaluate the performance of funds of hedge funds against a peer group because of the difficulty of comparing like with like. Instead, the analysis focuses on the ability of managers to achieve the targets they promise investors.

S&P has sought to meet the requirements of Europe’s leading investors by providing what is the only independent Europe-wide rating system for funds of hedge funds that focuses on qualitative as well as quantitative analysis. The rating process concentrates on the factors that ultimately determine whether and how a fund is meeting its risk/reward objectives, and the manager’s ability to sustain its performance in the future.

The S&P approach, which involves screening for minimum qualitative criteria as well as a quantitative filter based on Sharpe ratio, followed by qualitative analysis and assessment by a rating committee, focuses in particular on the thoroughness of manager’s due diligence process, ongoing supervision of the managers with which the fund of funds invests, and risk controls.

Following the award of a rating, funds of hedge funds are monitored quarterly for performance, operational changes and any other developments – such as significant changes in fund size or portfolio orientation – that might affect the manager’s ability to deliver performance in terms of the fund’s objectives.

Fund of hedge fund managers considering seeking a rating can contact S&P here.

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