Critical Capabilities of a Hedge Fund Performance Solution. By: State Street Global Services - Performance Services

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1 Critical Capabilities of a Hedge Fund Performance Solution By: State Street Global Services - Performance Services November 2015

2 KEY TAKEAWAYS Hedge fund managers are faced with an array of choices when it comes to a performance solution. Managers should consider the full scope of capabilities offered by the solutions they re evaluating, so the solution meets their evolving needs, today and tomorrow. Beyond their basic features, performance solutions vary; a complete solution that meets hedge fund managers changing needs will include these key features: daily time-weighted rates of return, daily linked returns to generate multi-period returns and risk statistics, daily returns calculated between fund and security level, contribution to return, availability of daily benchmark returns, money statistics, and daily reporting tools. Introduction Today, hedge fund managers can access an expanding landscape of tools to support their data, reporting and decision-making needs. As they evaluate hedge fund performance solutions, managers should consider the full scope of capabilities offered by each solution, to make sure that it meets their needs now and in the future. When it comes to their basic performance requirements, hedge fund managers unlike asset owners and longonly asset managers tend to be similar in their needs. Across the board, hedge fund managers need daily performance calculated at fund, security, and other levels in between fund and security, and they need contribution to fund return calculations. Beyond these basic requirements, however, the performance reporting needs of hedge fund managers vary. For example, an individual manager may not need to examine non-standard performance periods initially, but that need may evolve as the manager is asked to provide better analysis over specific time periods. That s why the best hedge fund performance solution will be flexible and include the most robust data and technology features, to accommodate the various and changing needs of all hedge fund managers. In this white paper, we will discuss the full range of capabilities that a complete hedge fund performance solution will include, in order to address the varying needs of all hedge fund managers as they arise. STATE STREET CORPORATION 1

3 The Critical Capabilities of a Hedge Fund Performance Solution A complete hedge fund performance solution will include these basic capabilities, along with the more advanced capabilities discussed in greater detail within each area: Daily time-weighted rates of return Daily linked returns to generate multi-period returns and risk statistics Daily returns calculated between fund and security level Contribution to return Availability of daily benchmark returns Money statistics Daily reporting tools STATE STREET CORPORATION 2

4 Daily time-weighted rates of return The first capability a hedge fund performance solution should include is daily time-weighted rates of return with drilldown to security level. This calculation of daily time-weighted returns will mitigate the impact of positive and negative cash flow timing impacts, and the ability to drill down to security level will help the investment manager understand what s driving their fund performance. A complete solution will also include these advanced capabilities: Carve-out and composite capability Flexibility to create sub-strategies of the overall fund strategy to meet specific strategic requirements. This includes the ability to carve out components of a fund to create a sub-strategy fund, or create composites of funds to combine strategies. Fee levels Flexibility to calculate returns other than simply net-of-fee returns. A complete solution will offer other types of returns, including gross of fee returns or hybrid fee returns such as gross of administration fees and net of manager fees. The flexibility to calculate gross returns supports return comparisons among managers on an apples to apples basis; with the different fees embedded in the net returns of managers removed, the managers can be evaluated purely on their investment skills. Flow recognition Flexibility to differentiate between beginning of day and end of day flow recognition in the performance calculation, to match real-world and accounting circumstances. A cash infusion to a fund on a given day may be considered to be in the fund at the beginning of the day so it should be reflected in the denominator of the daily return for the day. For another manager, a cash infusion may be treated as a flow that occurs at the end of day. This means there would be no denominator adjustment to the return that day since there was no investment of the cash on that day (and no marginal daily gains/losses in the return calculation). Daily linked returns to generate multi-period returns and risk statistics A complete hedge fund performance solution must include daily linked returns to generate multi-period returns and risk statistics, but it must go beyond calculating only the most commonly used historical rolling time periods, such as month-to-date, quarter-to-date and year-to-date returns. Since the goal of any manager is to achieve the highest return for the least amount of risk, the solution should also include risk-adjusted performance and volatility measures (ex-post risk), including: STATE STREET CORPORATION 3

5 Flexibility to calculate returns for different reporting periods A reporting solution may simply reflect a library of pre-programmed returns, but to give hedge fund managers complete reporting flexibility, a full hedge fund performance solution will empower the user to generate returns for any historical reporting period, on-the-fly. These query tools can support selection of a beginning date and an end date, to provide a point-to-point return, such as a return from Jan 8 to May 27. They may also allow the user to generate rolling time periods such as prior period annual returns as of a given end date with a single query. This flexibility to calculate returns for different time periods lets the manager analyze the impact of different investment strategies under various historical market conditions. Availability of risk-adjusted performance and volatility measures (ex-post risk) A comprehensive hedge fund performance solution will also allow users to calculate ex-post risk statistics generated from portfolio returns, benchmark returns and risk-free rates. While hedge fund managers use several risk statistics, these measures are most commonly seen in a performance solution: Sharpe ratio, Treynor ratio, Jensen s alpha, batting average, standard deviation, correlation coefficient, R-Squared, beta, number of positive/negative observations and percentage of positive/negative observations. Daily returns calculated between fund and security level To support the fund manager s decision-making process, a complete hedge fund performance solution will include capabilities that generate returns at standard levels (e.g. GICS sector) as well as custom, proprietary levels (e.g. Strategy A, B, etc.). The solution should be built to avoid these limitations: Limits on the number of return levels under fund level, and/or limits on sub-levels within levels Lag time between a security classification update and the new performance calculations that include the updates Contribution to return Hedge fund managers need a clean, arithmetic rollup of security/node contribution. That s why a complete performance reporting solution should also include contribution to return the basis point contribution of the security or node to the total level return, calculated for all performance time periods. In fact, most hedge fund managers consider security contribution to return more critical to their analysis than the security-level returns themselves. STATE STREET CORPORATION 4

6 The contribution must be calculated for all investment types in the portfolio, and the solution should use calculation methodologies that eliminate residual differences between fund return and the sum of the contributions across all time periods. Most managers don t have a specific methodology preference such as Frongello or proprietary; they simply look for the sum of the contributions to be tied to the total return. A complete reporting solution captures this feature. Availability of daily benchmark returns Without automated tools to feed daily indices into the performance system and to customize or blend indices, a hedge fund manager will find it challenging to conduct relative return analysis. That s why a complete hedge fund performance solution will allow hedge fund managers to report daily benchmark and relative return results, with features including: Support provision of thousands of market indices Advanced custom and blended benchmarking capabilities, such as blended benchmarks (combinations of indices) or a benchmark that reflects an index plus a hurdle rate (S&P bps) Money statistics A complete hedge fund performance solution will also include money-based statistics in its reporting. In the solution, Profit and Loss ( P&L ), a fixture on performance reports, is typically the numerator in the daily performance return calculation and in the security/node contribution to return calculation. A complete offering will also include these data points to help hedge fund managers analyze the drivers of their returns: Ending period Net Asset Value (NAV) and security positions Flow at all return levels (cash inflow/outflow, security transfers, purchases/sales) P&L decomposed to capital vs. income Daily reporting tools Finally, a complete hedge fund performance solution will include advanced reporting capabilities, to deliver performance results. STATE STREET CORPORATION 5

7 These reporting capabilities typically fall into three categories of tools: online performance user-interfaces, advanced report building tools and additional analytics, all detailed below. Online performance user-interfaces These tools allow users to seamlessly navigate through their performance results, so they can provide the most efficient analysis. Capabilities include: Configuration options to design your personal view Drilldown, click and drag, sort functionality Navigation tools Advanced report building tools These tools empower the user to create customized reporting, so they can provide necessary analysis and meet marketing requirements like professional performance booklets and fact sheets. Capabilities include: Tabular design tools Graphical design tools (pie/bar/line) Text box capability (manager commentary, header/footnotes, etc.) PDF upload capability (consolidate native and non-native reports, add a company logo) Additional analytics (calculated within core system or sourced from other systems) Report building tools may also deliver additional analytics content that goes beyond a traditional daily performance package. Capabilities include: Asset allocation (asset class, sector, sub-sector, country, etc.) Statement of asset value changes (ending value, beginning value, P&L, flows) Top/bottom holdings Top/bottom contributors Accounting reports with security level P&L STATE STREET CORPORATION 6

8 Exposure and liquidity reporting Advanced risk reporting such as daily VAR, stress testing and scenario analysis Conclusion To meet their data and reporting requirements, hedge fund managers must have an optimal hedge fund performance solution that covers their needs today while being flexible enough to meet their evolving needs tomorrow. The checklist of capabilities provided in this paper will assist managers in evaluating potential solutions to address all of these needs. We re ready to help you choose from the available options with confidence. Our hedge fund performance solution provides the full range of capabilities you need to meet reporting requirements while better understanding what drives your results. STATE STREET CORPORATION 7

9 Disclosures: This information is for general, marketing and/or informational purposes only and it does not constitute investment research or investment, legal, or tax advice. This document does not take into account any client s particular investment objectives, strategies, tax or legal status, or relevant regulations. It is not an offer or solicitation to buy or sell any product, service, or securities or any financial instrument, and it does not constitute any binding contractual arrangement or commitment of any kind. Any products or services described in this information will be provided only pursuant to a contract and fee schedule agreed to between the parties. State Street Corporation and its subsidiaries and affiliates ( State Street ) provide products and services to professional and institutional clients, and this is not directed at retail clients. Products and services referred to herein may not be available in all jurisdictions. Any opinions expressed in this document are subject to change without notice. This information has been prepared and obtained from sources believed to be reliable at the time of publication, however it is provided as-is and State Street makes no guarantee, representation, or warranty of any kind as to its accuracy, suitability, timeliness, merchantability, fitness for a particular purpose, non-infringement of third-party rights, etc. This information is not intended to be relied upon by any person or entity. State Street disclaims all liability, whether arising in contract, tort or otherwise, for any losses, liabilities, damages, expenses or costs arising, either direct or consequential, from or in connection with the use of this document and/or the information herein. No permission is granted to reprint, sell, copy, distribute, or modify any material herein, in any form or by any means without the prior written consent of State Street. Copyright 2015 State Street Corporation, All rights reserved. SSGSNA-0027 STATE STREET CORPORATION 8