The one advantage of a private sector reporting template is that it might influence investors. This explains the muted enthusiasm of managers for the standardised risk reporting template devised by consultants Albourne Partners. Regulators seem to like it too, but there are those who say Open Protocol does not always provide an accurate profile of risk.
Heads of operations at alternative fund management houses have a lot of regulatory reporting to do. What with Form PF, Form CPO-PQR, Annex IV of the Alternative Investment Fund Managers Directive (AIFMD), the 85 fields of European Market Infrastructure Regulation (EMIR), the  reporting fields of the revised Markets in Financial Instruments Directive (MiFID II) and the Foreign Account Tax Compliance Act (FATCA), there is barely time to do anything but gather data on behalf of regulators.
So a modicum of exasperation was understandable when private sector investment consultants Albourne Partners unveiled the opportunity to respond to their Open Protocol Enabling Risk Aggregation (formerly known as OPERA, and now called Open Protocol for short) initiative. Launched in August 2011, Open Protocol is a risk reporting service originally designed to bring about greater transparency to an alternative investment management industry long criticised for its opacity.
The Open Protocol aims to standardise risk reporting and disclosure to end-investors. This is potentially useful at a time when – as the list of demands which heads this article suggests - regulatory risk reporting is anything but consistent. Not being a regulator-driven initiative, there are no penalties for non-compliance with Open Protocol, but Albourne Partners has secured a high degree of compliance simply because a failure to sign up to the project is likely to hinder capital-raising opportunities with investors who want to see the data. As Table 1 underlines, Albourne Partners did attract support for the idea of Open Protocol from some hedge fund managers (unexpectedly) as well as investors (predictably) and service providers (opportunistically).
Source: Albourne Partners
A survey of 1,489 fund managers by Albourne Partners in 2012 found 31 per cent claimed to have compiled, or were in the process of compiling Open Protocol reports. A mere fourteenth said they had no intention whatsoever of filing an Open Protocol report, while more than half (52 per cent) acknowledged that they would do so if either their service providers could do it for them, or if an investor demanded it of them.
Of 200 investors surveyed by Albourne Partners, nearly half (49 per cent) confessed to a “strong interest” and most of the rest (47 per cent) to “interest” in the Open Protocol. “Investors, particularly funds of hedge funds and institutions, want to receive copies of the Open Protocol because it gives them increased transparency and they require their managers to provide them with risk reporting anyway,” says Paul Clement, partner and director of operations at Castilium Capital, a recently launched hedge fund in London. “As the risk reporting data is standardised, it helps investors aggregate their risk data which should enable them to better manage their overall portfolio risk.”
The growing clout of investment consultants such as Albourne Partners – increasingly at the expense of funds of hedge funds – is well documented. A 2013 survey of institutional investors by the prime brokerage arm of Goldman Sachs found 65 per cent of pension funds and 45 per cent of insurance companies employed consultants to assist them with their hedge fund allocations. A 2014 study by Barclays Prime Finance estimated investment consultants control approximately $830 billion invested in alternative assets, or just under a third of the $2.7 trillion managed globally by hedge funds.
Of that $830 billion, Barclays says Albourne Partners advise $288 billion, although sources close to the firm put that figure even higher, at approximately $350 billion. Albourne Partners, despite offering purely advisory services and not managing capital on behalf of any of its clients, is widely considered to be the most powerful and influential source of funds for hedge fund managers in the world. Ignoring its call for data is scarcely an option for capital-hungry hedge fund managers. “Managers are increasingly interested in using the Open Protocol,” says Robert Mirsky, global head of hedge funds at KPMG in New York.
Despite this enthusiasm, and the Albourne Partners’ survey findings, fund manager take-up of Open Protocol in 2011 and 2012 was muted. As late as September 2013, just 150 funds were reported to be filing Open Protocol reports. Albourne Partners’ founder and CEO Simon Ruddick was forced to warn managers that they faced being relegated from an approved list of hedge fund managers if they failed to support Open Protocol. It was an approach which irked many managers at the time, but the majority got the point, and sign-ups rapidly accelerated.
Gaurav Amin, head of risk at Albourne Partners in London, believes the early stage aversion among managers to Open Protocol was attributable to the sheer volume of regulatory reporting elsewhere. “The Open Protocol was launched at a time when managers were working out how to file Form PF with the Securities and Exchange Commission (SEC) and Form CPO-PQR with the National Futures Association (NFA),” he says. “Many simply did not have the time and resources at hand to deal with Open Protocol. However, as managers have got to grips with these regulatory reporting requirements, there has been a significant improvement in the number of managers filing Open Protocol. We hope to more than double the number of managers signing up to Open Protocol by assets to $2 trillion by the end of this year from $1 trillion today.”
The Open Protocol template, put simply, aims to standardise hedge fund reporting procedures, from collection, through collation, to delivery. Data must be supplied monthly, and includes firm, fund and investor details, plus exposures by asset class: equities, rates, credit, convertibles, currencies, real estate and commodities. Managers also have to report the techniques they use to manage the risks posed by their portfolios. In practice, that means Value at Risk (VaR) calculations, sensitivity analyses, stress tests and counterparty risk management processes. Managers can elect to report this information into Open Protocol at three different levels of granularity on a scale of one to three, with three being the most transparent and detailed. “Most managers are reporting to a level one standard,” says Amin.
Some over-worked COOs complain about the time it takes to complete Open Protocol, while others bemoan the additional costs of yet another report to file. A more telling criticism of Open Protocol from managers is that they already supply bespoke risk reports to clients, and Open Protocol adds little to those documents. “Some managers complain they already compile risk reports and Open Protocol is an added burden,” says Amin. “There are still some old school managers that are loath to complete Open Protocol but new school managers are certainly more willing to oblige. However, if a manager fills in Open Protocol, it helps them consolidate client data and their demands, which in turn improves investor-manager relations. It makes more sense to compile one Open Protocol report and distribute it to all of your underlying clients rather than 130 different, bespoke risk reports.”
But, whatever the gripe and whatever the riposte from Albourne Partners, the fact is that more managers are filing Open Protocol today than last year. The rising uptake is assisted by the growing number of service providers offering Open Protocol reporting templates. Listed on the Open Protocol web site, they include AQMetrics, Citco, ConceptOne, SS&C GlobeOp, Harmonic, Hedgemark, HedgeServ, Imagine Software, Indus Valley Partners, Investor Analytics, Klarity Risk, MSCI, State Street and Whitebox. Other providers, including Viteos, also support Open Protocol reporting when required. “We can provide clients with Open Protocol reports but not many are asking for it,” says Jonathan White, head of business development at Viteos in New York. “We tend to focus mainly on their regulatory reporting needs.”
Some managers are finding Open Protocol reporting less than straightforward. The methodologies devised by Albourne Partners can, say some managers, misrepresent their position, and so lead to misunderstandings. A particular criticism is that the methodology is not appropriate for managers running distressed, credit, illiquid or long-term strategies. “Managers in distressed debt feel VaR calculations are often skewed as they argue the long term nature of their investment approach allows them to ride out short term volatility,” explains Clement. “The methodology designed by Albourne Partners can make those managers appear more volatile than they believe they actually are. For managers that trade more tactically, this is not a problem.”
Jim Ramenda, senior vice president, Enterprise Risk, at SS&C GlobeOp, agrees. “Many distressed managers do not rely on VaR, and that is a big component of Open Protocol,” he says. “Some of these distressed managers complain that aspects of the Open Protocol are not entirely relevant to them. VaR calculations typically rely on historical correlations, but when an instrument becomes distressed, its historical correlations generally no longer apply. In fairness to Open Protocol, a key purpose of the Open Protocol is to aggregate the risks of different funds, and not necessarily to look at risk for each individual fund.”
Other industry experts have more detailed criticisms. “Open Protocol hopelessly conflates rate and credit risk in some cases, and disconnects it in others,” says one. “A fund, for example, holding a non-US corporate bond denominated in US dollars that hedges out the US rate risk with a short treasury is shown by Open Protocol to be long credit and short rates without any indication that the short is there specifically to hedge the rate exposure in the credit. On the other hand, an emerging markets bond denominated in US dollars and a bond from the same country denominated in local currency would be shown by Open Protocol on the same page without any ability to separate out what exposure is related to local rates versus external rates versus credit. There are also problems with the geographical categorisations in Open Protocol. The geographical groupings can serve to obfuscate exposures rather than to clarify them. They are somewhat arbitrary and do not always line up to how most investors think about regional exposure.”
The same expert also argues that Open Protocol fails in its core mission by over-simplifying risk. “The standardisation of risk reporting in the Open Protocol is the key selling point of the initiative,” he says. “But it is also the biggest flaw in that it conflates risk. It over-simplifies risk, so some strategies appear to be more risky than they actually are while others seem to be less risky, according to the Open Protocol interpretation.”
This argument will likely run for some time. What will help defeat the sceptics is the rising level of interest in Open Protocol from regulators. The Australian Prudential Regulation Authority (APRA) has made it no secret of the fact that it would like fund managers to provide Open Protocol reports if they manage money on behalf of any of funds that make up the $1.5 trillion superannuation funds industry. “While APRA has not mandated fund managers fill in the Open Protocol, the regulator has strongly encouraged it,” says Amin. “APRA wants the superannuation funds to receive consistent reporting across all of their investments.”
Joe Vittoria, chief executive officer at Mirabella Financial Services, a regulatory hosting platform owned by the Cordium Group, argues the Australian endorsement is a powerful one. “The Australian superannuation funds market is meaningful,” he says. “The fact a regulatory agency has recognised the value of the Open Protocol is a good endorsement.” But APRA is still the exception, not the rule. Both the SEC in the United States and the European Securities and Markets Authority (ESMA) in Europe have yet to incorporate Open Protocol methodologies into their own regulatory reports.
Ironically, it is something managers as well as investors would welcome, as a contribution to consistency across reporting obligations. In fact, a technical submission to ESMA on the issue by Albourne Partners gathered 242 signatures globally. Conversations with the SEC are still on-going. “It would be fantastic if ESMA and the SEC incorporated Open Protocol into Annex IV and Form PF respectively,” says Clement. “But I suspect it will take a while to reach some sort of a compromise.”
The introduction of the Solvency II capital adequacy regime for insurers and the Basel III capital adequacy regime for banks will probably do more to boost the adoption of Open Protocol. The Solvency II Directive, issued by the European Commission, requires insurers allocating to hedge funds to hold capital equivalent to 49 per cent of the investment. Naturally, this measure encourages managers to disclose data at an exceptionally granular level just to keep the insurers in their investment. If a manager reports underlying positions individually, and calculates the risk weightings carefully, insurers might even benefit from a lower capital charge.
The same applies to banks under Basel III. “Solvency II and Basel III require insurers and banks investing into hedge funds to set aside capital equivalent to 49 per cent of the value of the investment,” says Amin. “If managers do not disclose position-level data, their investors will have high capital charges. If investors can show they receive a lot of transparency from their managers, the capital charges will be low. Managers can do this by providing the Open Protocol to their clients.”
So far, however, the alternative investment management industry is divided about Open Protocol. Some managers view it as just another reporting headache, while others see it as a marketing exercise. Only a minority of managers are positively enthusiastic. “If you file Open Protocol, it enables managers to get onto the Albourne Partners' network, which certainly helps their firms from an investment point of view,” says Clement. “The Open Protocol is also a way of standardising risk data, which is obviously welcome.”
Where the Open Protocol initiative is definitely gaining traction is among institutional investors, and this is driving adoption by managers. Amin himself expects signatories to Open Protocol to double I terms of AuM by the end of 2014. Whether or not the Open Protocol methodology is adopted by the SEC and ESMA as well as APRA, Open Protocol is here to stay.