Hedge funds are notorious for disclosing as little information as they can on their positions, and for good reason. Since they are looking for unique and often idiosyncratic investment opportunities, letting competitors know their plans can easily blow up in their face. But investors want to know where their money is invested and striking a balance between these two legitimate concerns is no easy task.

Risk transparency helps prevent style drift

“Monitoring style discipline in opaque alternative assets, while challenging, is a necessity. Aggregated on a total portfolio level, style drift can cause significant variance from policy for institutional investors. Investors want assurance that managers are delivering the style exposure they promised,” writes Carl G. Lingenfelter chief administration officer of Northern Trust Hedge Fund Services.

He argues that the main reason investors want more information from hedge funds is so that they can figure out how to best allocate the rest of their portfolio within their risk and style preferences, but they can do this by knowing which risks they are exposed to without knowing the positions themselves.

Drawing on the risk premia theory of portfolio management, Lingenfelter thinks that hedge funds should embrace risk transparency which reveals the types of risks investors are exposed to without telling them which positions the fund actually holds.

“While investors continue to seek holdings-level transparency, many managers are reluctant to disclose this level of detail as they seek to protect their proprietary trading strategies. Risk transparency is emerging as one option that can meet the needs of both investors and managers,” he writes.

Risk transparency could be a differentiator for hedge funds

Lingenfelter also claims that risk transparency is a source of alpha for investors. His argument is that alpha is the risk-adjusted rate of return above some benchmark. From the point of view of the hedge fund manager, transparency doesn’t increase alpha (and may hurt it if a rival firm uses information against him), but the calculation is different for investors. For them, the typical opacity that most hedge funds practice is a source of risk, which decreases risk-adjusted returns by definition.

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Hedge fund managers may initially balk at this way of measuring alpha (or at the cost of additional reporting), but Lingenfelter (whose company provides services like this) hopes that risk transparency will become a key differentiator that hedge funds use to attract business. Since investors have demanded third-party valuation audits, he doesn’t see any reason that third-party risk audits won’t also become the norm.