Big chips! (Woo!) We off in Vegas drinking and partying
We got chicks in swimsuits modeling
We in the twin stretch Maybachs dipping low
The way the wrist shine it’s so magical
When it comes to the hedge fund industry, where billions of dollars are made and lost each year due in part to the accuracy of information, precise measurement and reporting on the scale of the industry itself appears frustratingly imprecise and hence unimportant. At the end of the fourth quarter of 2011, estimates of hedge fund industry assets under management (AuM) ranged from a low of $1.64 trillion to a high of $2 trillion or more, an astounding difference of at least 50%. Our estimate through January 2012 was $2.04 trillion.
Two factors may be to blame: producers of AuM estimates may be reluctant to share methodologies behind the estimates and media reporters may be reluctant to question a source for fear of losing access to information.
But here is some background that might provide some insight and clarity on the size of the hedge fund industry.
There are two important parts to measuring the size of the hedge fund industry over time. The first is to accurately estimate total industry size and the second is to accurately measure its change over time. There is decidedly less variation in published estimates of % change over time, but when these changes are applied to actual size it makes a very large difference.
Granted, accurately measuring the size of the industry is difficult. It requires gathering information on fund assets from famously shy sources and then assuming asset information gathered is accurate and comprehensive. Currently, there are three primary methodologies used in published estimated of industry size:
1. Assets reported to a hedge fund database are summed with information gathered from various external sources, the result of which is assumed to be a certain fraction of the industry. The sum is then factored up to produce an estimate of total industry size.
2. A survey of specific industry participants is conducted and an assumption is made about the portion of the industry for which they account. Refined survey results are factored up to produce an estimate of total industry size.
The key to accuracy is making the smallest assumptions possible. Let’s look at the assumptions required for Methods 1 and 2, disregarding Method 3 because it has no sound basis. Method 1 utilizes a hedge fund database, external collection efforts and a factor assumption. The immediate issue is that the majority of the largest firms may not report to commercial hedge fund databases. Those that do may or may not report all of their hedge fund products and for those products they do report, they may or may not include current AUM. External collection efforts face the same hurdles in accuracy and breadth. A factor assumption, assuming data summed is X % of the whole pie, is based on the quality of the efforts in parts one and two. It is evident the assumptions being made are numerous and large. Surprisingly, the most widely quoted industry AUM estimates are produced using Method 1.
Method 2. Twice a year, currently in its 10th iteration, more than 60 hedge fund administrators, including all of the largest, are surveyed to report hedge fund assets under administration (AuA) along with, but separate from fund of funds, UCITS and Other Alternatives AuA, which includes private equity and real estate. The hedge fund portion of the survey results are refined to take into account reporting anomalies such as the exact month through which information is compiled and submitted. These and other refinements are the result of direct communication with administrators. The refined AuA figure is increased by an estimate of what % of hedge fund assets are administered externally to produce an estimate of total hedge fund AUM.
Method 2 addresses the accuracy and breadth issues with Method 1. A primary function of administrators is to provide funds and investors precise accounting of their holdings and balances and the vast majority of the industry utilizes external administrators. In a post-Madoff world, funds are typically required to have external administrators to receive large allocations. Additionally, when new funds are launched or when funds are liquidated, the information feeds through fund administrators, whereas this information is rarely available elsewhere.
The perceived issue with Method 2 is getting accurate information from hedge fund administrators, yet their businesses are built primarily to provide accuracy. Large hedge fund firms are currently relying on administrators to accurately aggregate information to be submitted through Form PF to the Securities and Exchange Commission in the second half of 2012. Additionally, many administrators are publicly traded entities and reporting to a survey is a public representation of their business.
Both Method 1 and 2 are imperfect at estimating the total size of the hedge fund industry, but there are clear differences in the level of assumptions required in each. These assumptions, along with the common publication of estimates which rely on Method 3, are the reason published hedge fund industry AUM figures are so far apart.
The financial media is required to produce a large amount of content at an increasingly high frequency, so it is understandable that using information more commonly seen, more commonly accepted or at their fingertips is the road often travelled. As a reader, the next time you see a story quoting the size of the hedge fund industry, take a minute to think about how that information is generated. If you do, you are one step ahead of many.