Gauging Form PF: Data Tolerances In Regulatory Reporting On Hedge Fund Risk Exposures by OFR
Mark D. Flood
Office of Financial Research
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Office of Financial Research
Federal Reserve Bank of Chicago
July 30, 2015
This paper examines the precision of the U.S. Securities and Exchange Commission’s Form PF as an instrument for measuring market risk exposures in the hedge fund industry. We introduce a novel methodology that systematically presents the measurement instrument, Form PF, with a range of simulated portfolios with observable characteristics. We assess the measurement tolerances of Form PF by examining the range of actual market risk exposures – measured directly from portfolio details – that are consistent with a given, fixed presentation on the form. We find that Form PF’s measurement tolerances are sufficiently large to allow private funds with dissimilar actual risk profiles to report similar risks to regulators. We also find that the form’s stratification by value at risk (Form PF Question 40) helps significantly to narrow the measurement tolerances.
Data Tolerances In Regulatory Reporting On Hedge Fund Risk Exposures – Introduction
This paper examines the precision of the U.S. Securities and Exchange Commission’s (SEC) Form PF as an instrument for measuring market risk exposures in the hedge fund industry. We introduce a novel methodology that systematically presents the measurement instrument, Form PF, with a range of simulated portfolios with observable characteristics. We assess the measurement tolerances of Form PF by examining the minimum-maximum range of actual market risk exposures – measured directly from portfolio details – that are consistent with a fixed presentation of the portfolio on the form.
Every measurement framework faces the challenge of precision. We find that Form PF’s measurement tolerances are significant, and may obscure reporting funds’ actual risks. For example, the maximum expected shortfall for our factor-alpha strategy across our sample of portfolios varies from 85 to 278 percent above the median value in four versions of expected shortfall. On the other hand, we also find that the form’s stratification by value at risk (VaR), under Form PF Question 40, significantly reduces the range of possible differences between reported and actual market risk exposures. For example, the comparable results for expected shortfall in this case range (with the same ordering) from 15 to 85 percent higher than the median. This improvement in precision does not eliminate fully the potential for inaccuracies. Moreover, our results are conservative in the set of risk measures examined and portfolio strategies allowed, and thus represent a lower bound on the actual tolerances expected in more realistic portfolios. The constrained maximization methodology we present could be a useful tool in assessing Form PF or designing future regulatory risk reports.
Hedge funds are part of a broader ecosystem of investable capital that pool investors’ wealth to achieve economies of scale in portfolio management. Hedge funds can differ from other asset managers, such as mutual funds, private equity, and family offices, because SEC rules give hedge funds regulatory relief from certain terms of the Investment Company Act of 1940 (the “1940 Act”), exempting them from many investment constraints and disclosure and registration requirements while restricting their class of investors. This exemption from scrutiny has helped hedge funds to implement flexible and sophisticated portfolio strategies. The crisis of Long-Term Capital Management L.P. (LTCM) in 1998 revealed that financial troubles at hedge funds could have systemic implications. The financial crisis of 2007-09, which included a significant disruption to quant funds as a significant foreshock in August 2007 (see Khandani and Lo ), reinvigorated these concerns. In the wake of the crisis Congress mandated enhanced regulatory reporting on private funds, including hedge funds, with the twin goals of investor protection and systemic risk assessment. The mandate was part of much broader financial reforms under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act); see U.S. Congress .
Form PF is the primary regulatory implementation of that mandate. Form PF is still quite new, and regulators – the SEC and the Commodity Futures Trading Commission (CFTC) – are required by law to hold the reported numbers closely confidential. As a result, research on Form PF is relatively sparse. However, the form itself is public information, and industry commentary has accumulated as funds have worked to comply with the new reporting requirement. The methodology discussed here is notable in that it does not require any confidential information, such as actual Form PF reports.3 In principle, anyone with access to the form and its instructions can repeat or extend the analysis.
The remainder of the paper proceeds in four sections. Section 1 discusses the debates on the possibilities for hedge funds to create systemic hazards, and policy responses that culminated in the reporting of exposures on Form PF. Some of these vulnerabilities point to actual crises, such as the LTCM failure, while others are informed conjectures. Section 2 discusses the structure of Form PF itself, and how it attempts to measure market risk exposures. Section 3 introduces the details of our simulation methodology and Section 4 presents the results and conclusions.
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