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Street Sleuth
Race to Rate Hedge Funds Begins in Heavy Fog


By SCOTT PATTERSON
The Wall Street Journal
September 28, 2005; Page C1

If you are thinking about investing in a hedge fund, you probably want to figure out how it stacks up against the competition.

Good luck.

The trillion-dollar business, which caters to wealthy individuals and institutions, is cloaked in secrecy, making reliable comparisons all but impossible. Now, several companies are scrambling to provide the world of hedge funds what already is available in the mutual-fund industry: dependable ratings.

They would be based not only on performance -- there already is plenty of that data available -- but also on management track records, risk levels, governance structures and other information collected by independent researchers.

"There's no one source" for ratings, says Joel Schwab, managing director of Channel Capital Group, a New York hedge-fund-services firm. "That's the race that's going on right now."

The race is fueled by the exploding popularity of hedge funds, which are lightly regulated and notoriously closed-mouthed about their often complex and risky investments. There are now about 8,000 active hedge funds, but many -- perhaps thousands -- don't even report performance data to any independent database. This summer's collapse of Bayou Management LLC, which had attracted more than $300 million in investments despite numerous warning flags, underscores the potential appetite for independent information.

Among those hoping to fill the void is Morningstar Inc., well known for its one-to-five "star" ratings on mutual funds. It has compiled 2,000 names so far in a database of hedge funds and funds of funds -- vehicles that invest in multiple hedge funds. The firm wants to move beyond performance data. "We're looking at ways of rating hedge funds," said John Rekenthaler, vice president of research.

Reuters Group PLC, parent of mutual-fund research firm Lipper Inc., purchased the TASS Research database, which tracks about 4,000 active hedge funds and funds of funds, and its related HedgeWorld Web site from Tremont Capital Management. Andrew Clark, a senior research analyst at Lipper, says the company may apply a form of its mutual-fund-ratings system to hedge funds in the coming years.

One small New Jersey outfit, Sky Fund, started rating hedge funds in 2003 and now follows nearly 6,000. The ratings take into account cash under management, leverage, volatility, historic returns and other criteria, says Joseph Omansky, Sky Fund's founder.

Some industry watchers contend that comprehensive and widely accepted ratings will remain elusive until the industry becomes less opaque.

"It's unfeasible that hedge funds will be rated in today's environment," says Joshua Rosenberg, president of Chicago-based Hedge Fund Research, which has a database that tracks the performance of more than 5,000 hedge funds and funds of funds.

Sky Fund's Mr. Omansky says ratings skeptics are just trying to protect turf. "Clearly, you can rate hedge funds," he says. Industry insiders are "critical of anybody who tries to simplify their money-management expertise."

A number of other outfits track individual hedge-fund performance and use that data for industrywide measures, including Lehman Brothers Holdings Inc., which recently announced an index based on a database of nearly 5,000 hedge funds and funds of funds that report performance to HedgeFund.net, which is owned by Channel Capital Group.

Industrywide measures, however, suffer from the same defect afflicting such data on mutual funds: They exclude poorly performing funds that have been liquidated or merged into other funds. Experts say this so-called survivorship bias inflates annual overall mutual-fund performance by more than a percentage point. Hedge funds present a bigger problem. Mutual funds are required to disclose performance data, but hedge funds can choose not to, so poorly performing funds probably tend to be less forthcoming, while better ones might not feel the need.

AllenBridge HedgeInfo, a London-based consultancy, has rated overseas hedge funds since 2000 -- but it doesn't rate poor-performing funds because it fears that those dinged with a low rating would stop reporting results, degrading the overall integrity of its database.

Under Securities and Exchange Commission rules, mutual funds are required to divulge lots of information, in addition to results, that research companies use in rating them, including holdings. Mutual funds also make managers available so rating researchers can evaluate their strategies and risks.

A new SEC rule will require the biggest hedge-fund managers to register as investment advisers starting in February, but the industry is otherwise largely unregulated. Hedge funds usually won't reveal their complicated strategies because they don't want them copied.

Driving the push for independent ratings are deep pockets -- pension funds and endowments, which answer to oversight boards that crave simple methods for evaluating and justifying investments. "We can hear it from our clients, and we know generally that there is this push," says Michael Tito, vice president for Wilshire Associates' hedge-fund group.

Some funds are coming around. Several recently approached Standard & Poor's for creditworthiness assessments, which may be useful in attracting investors. "We sense it's a growing interest on the part of the hedge funds to be rated," says Tanya Azarchs, managing director of S&P's Financial Services Ratings Group.

Many in the industry say it is unfair to compare individual hedge funds with each other, let alone with benchmarks like the Standard & Poor's 500-stock index, because their strategies are too varied and complicated.

"It's very difficult to come up with a generic methodology that's applicable to all funds," says Marc Roston, senior portfolio manager of Silver Creek Capital Management, a fund of funds based in Seattle with more than $4 billion under management. (Silver Creek invested in Bayou before that hedge fund collapsed.) It can take years for the results of some thinly traded investments, such as shares of small companies, to be fully realized. That makes periodic performance estimates fuzzy at best and, at worst, prone to manipulation.

Eventually, however, resistance may melt away. When Morningstar began ranking mutual funds in 1985, it encountered resistance from fund firms that didn't want to disclose any more than what they submitted to the SEC. Initially, Morningstar didn't have the capacity to cover all mutual funds, but eventually even poorly performing funds lobbied to be rated, because financial advisers stopped recommending unrated funds.

If the ratings companies "get big enough and they have enough influence, managers will be compelled to report to them," says Tremont President Barry Colvin. "That's just part of the evolutionary process."

URL for this article:
http://online.wsj.com/public/article/SB112786630602054027-dyjiw_V3VZsykc8Y0Rtdy7nNZa4_20061001.html?mod=rss_free
Sky Fund's Mr. Omansky says ratings skeptics are just trying to protect turf. "Clearly, you can rate hedge funds," he says.

Industry insiders are "critical of anybody who tries to simplify their money-management expertise."

One small New Jersey outfit, Sky Fund, started rating hedge funds in 2003 and now follows nearly 6,000.

The ratings take into account cash under management, leverage, volatility, historic returns and other criteria, says Joseph Omansky, Sky Fund's founder.


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