Shedding light?

At first glance, ratings on hedge funds seem like a good idea. The industry is notoriously opaque and regulators on both sides of the Atlantic have been increasingly vocal in their calls for greater transparency in the sector.

The rating agencies are, for the most part, focusing on operational infrastructure, including valuation processes, net-asset-value calculations, auditors and compliance. What they don't cover, however, is the composition of portfolios, outstanding trading positions, details of credit exposures and intricate particulars of the firm's trading strategy.

And few in the industry are suggesting they should. Hedge funds make their money by exploiting trading opportunities that few other people have spotted. To give away details of trading strategy to any outside party, just for the sake of a rating, could be damaging in the extreme.

In fact, the operational ratings have been welcomed by some hedge fund managers. They point to Connecticut-based Bayou Management, which collapsed last year after it was revealed the firm had managed to hide trading losses and used a bogus accounting firm to audit its financial statements. An independent, third-party validation of their control processes will give investors greater comfort, they argue.

But there have been plenty of doubts. For a start, start-ups are unlikely to seek ratings, as they won't have sufficient infrastructure or back-office personnel to make it worth their while. Only the largest funds are likely to tick all the boxes required for a high rating - and many of these may decide to rely on their established track records rather than pay to obtain a rating. Anybody that uses the ratings for comparison may therefore not be getting a full picture of the industry.

There's also the risk that investors won't understand what the ratings represent, and - even worse - use them as a basis for investment. Imagine an investor putting cash into an AAA-equivalent hedge fund only to discover that the fund then makes a disastrous, large-sized bet on natural gas.

The same thing happened in the collateralised debt obligation market a few years ago - investors made their decisions based solely on ratings, without fully understanding the risks of the product. Subsequent losses in the asset class in 2002 led to something of a backlash from investors. Are rating agencies taking on reputational risk in entering the hedge fund space?

At the other end of the scale, funds of hedge funds - the largest hedge fund investors - are unlikely to ditch their own due diligence processes. At best, they will use the ratings as a comparison.

Any attempt to validate hedge funds' operational controls, compliance and risk management has to be applauded. Whether the hedge fund ratings take off, however, is a different question.

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- Nick Sawyer, Editor.