The increased disclosure by managers to regulators has prompted some allocators to ask if they can see the submissions. Managers worry about the consequences for their relationships with investors, and the associated legal and regulatory risks, but there is an obvious solution.

Transparency may be one of the great cant terms of our time, but the fact that regulators are collecting so much information from fund managers means it is no longer a completely impracticable idea. Investors are unlikely to be comfortable for long with the idea that regulators know more about their investments and investment managers than they do, and there are already signs that some are pressing managers to share the contents of Forms PF and CPO-PQR and Annex IV of the Alternative Investment Fund Managers Directive (AIFMD).

For the hedge fund industry, this is a genuine novelty. After all, the transparent hedge fund was an oxymoron prior to the great financial crisis. In the golden era hedge fund investing, managers could afford to ignore investors which made allocations contingent on disclosure of details about how their investment strategies made money, since they was always a less picky investor just a telephone call away. Typically, investors received a monthly or quarterly or even annual fact sheet via the fund administrator - whose answerability to the manager jarred with the fact that the investors were paying for the service - containing nothing the manager did not want investors to know.

Madoff undermined that secretive style. It is one of many ways in which the great fraudster changed the hedge fund industry, even though he was not even running a hedge fund. The responsibility was not solely his, of course. In the immediate aftermath of the great financial crisis, many investors were dismayed to be gated, or to find the manager had invested in illiquid assets, or drifted far from the investment strategy they had selected when making the allocation, and that he or she often had little or no idea who their investors actually were. In the more difficult capital-raising environment after 2008, allocators not only demanded greater disclosure, but got it. Nowadays, if a manager does not provide adequate levels of transparency to a prospective investor, the fund is unlikely to attract capital.

That transparency extends beyond the investment management methodology. The clout of the operational due diligence (ODD) teams formed by major institutional investors and funds of funds has grown exponentially since the financial crisis. A study by Deutsche Bank Markets Prime Finance in July 2013 found that 70 per cent of ODD teams at institutional investors had an explicit power of veto over allocations if they were unconvinced by the operational infrastructure, and that this was exercised surprisingly often: in almost one in ten manager reviews in 2012. Passing an ODD test now takes longer too. A Deutsche Bank study found that by 2012 twice as many investors (66 per cent) took between three and six months to complete an ODD compared to 2003 (33 per cent).

The calibre of ODD professionals is higher than it was. Most now have a legal or compliance background, chiefly because investors now track compliance with regulations even more than their adherence to their own best practices. Transparency into how a firm complies with the rising tide of regulation is no longer optional. A survey of managers by Preqin, a London-based data provider, found investor demands for information about regulatory compliance was second only to risk and performance in terms of its impact on managers. The result is more frequent and more detailed reporting to investors. A quarter of managers told Preqin they were reporting to their investors more often. So it is scarcely surprising that some investors want to see even more: the information supplied by managers to regulators.

The Form PF submitted by managers to the Securities and Exchange Commission (SEC) under the Dodd-Frank Act is an obvious target for the inquisitive investor. It obliges managers to supply some 3,000 data points, including exposures by asset class, counterparties, geographical concentration, leverage and risk profile, details of investors and their liquidity terms, investment strategies, turnover by asset class, stress test results and Value at Risk (VaR) calculations. The usefulness of this information is questioned by some investors. “Realistically, a lot of the information contained in Forms PF or CPO-PQR is data that either we already have from our managers or that is not as helpful to us as the data that we do receive from managers," says Emma Rodriguez-Ayala, general counsel at Mesirow Advanced Strategies, the $14 billion Chicago-based fund of hedge funds. "For investors, like us, that already get significant risk reporting from managers, the data contained in these forms is unlikely to be life-changing and would mostly be used to confirm the accuracy of information that the investor has already received.”

Mike Hughes, global head of fund services at Deutsche Bank, says he has not yet heard of investors demanding regulatory reports. “We are not aware of investors asking managers or ourselves for copies of regulatory reports such as Form PF, CPO-PQR or even Annex IV,” he says. “Investors will receive reports from managers thanks to the AIFMD, which is good for the sake of transparency. However, the value of supplying these complex reports to investors is open to debate.” Certainly, managers are not always enthusiastic about sharing regulatory submissions with investors, since they cannot control the context in which the information is presented. Some say they are happy to provide redacted versions of Form PF only, with the most sensitive or proprietary data expunged.

Other managers have said they are open to investors perusing the document in its entirety at their offices, on condition that it is neither removed nor photocopied. “Some managers are disclosing Form PF filings or parts thereof to investors,” says Jonathan White, head of business development at Viteos Fund Services in New York. “Others are not. Likewise, some investors ask for Form PF and others do not. My position, which is broadly in line with the investor community, is that if a manager passes the costs of completing Form PF to the investor, then the investor should have every right to see the document.”

At Mesirow, Emma Rodriguez-Ayala concurs, but adds that managers which fund the costs of filing reports out of the management fee are at liberty not to disclose it. "First, we at Mesirow Advanced Strategies do not like it when managers pass through the costs of filing Form PF and Form CPO-PQR to the fund,” she says. “We feel that regulatory reports such as these are all part of the cost of running a hedge fund advisory business and should be paid for by the manager. If the manager itself pays for the Form PF, then we are more likely to understand that they might not want to supply us with the data for a variety of reasons. But if Form PF and Form CPO-PQR are being charged to the fund, the manager should provide it to the investor if requested since the investor paid for it. In our experience, hedge fund managers - for the most part - are not charging Forms PF or CPO-PQR to their funds."

A number of practical arguments are advanced against supplying regulatory reports to clients. First, there are differences between risk reports supplied to regulators (whose role is to monitor systemic risks in capital markets) and investment reports provided to allocators (whose role is to assess investment and operational risk). “The data and methodologies in regulatory reports versus reports demanded by consultants and allocators can be different,” explains Stuart Feffer, senior vice president and co-head of global hedge fund services at Wells Fargo in New York. “The numbers are sometimes different and can be based on different methodologies. If a manager is SEC-registered, most investors will look at their Form ADV, which is publicly accessible. Very few investors request a Form PF, however, and when requested we have not seen managers making it available.”

The differences between regulatory and investment reports become obvious if a comparison is made between the Regulatory Assets under Management (RAuM) figure demanded by Forms PF, CPO-PQR and Annex IV and the standard Assets under Management (AuM) figure provided to investors in risk reports. RAuM, unlike AuM, incorporates leverage and the notional value of derivatives contracts, so assets appear far larger in regulatory reports than they do in investment reports. This could lead to confusion, and ill-informed questions. “The data is just that – data,” says Ian Shaw, managing director for the alternative investment services business at BNY Mellon. “If you do not have a detailed understanding of the methodology used to calculate [the data], and what is included or excluded, it could be confusing for investors.”

This is not simply a question of understanding what the regulators asked for. Although the SEC has inevitably adopted a one-size-fits-all approach to risk measurements, asset class categories and RAuM calculations, the way managers actually respond to the questions in Form PF varies. The answers may even contradict or fail to be consistent with what the same managers told their investors in an investment report. This inconsistency across answers to apparently identical questions alarms managers who think it could discomfort investors.

Although the likelihood of institutional investors in North America or Western Europe failing to grasp the methodological and quantitative distinctions between investor risk reports and regulatory risk reports is low, the same may not apply to investors from further afield. “US institutional investors will understand that the data within Form PF and CPO-PQR is different from a risk report they will typically receive,” explains Emma Rodriguez-Ayala. “Sophisticated investors do know enough about regulation and compliance to understand that RAuM and AuM in Form PF will be higher, and the reasons behind it. Trouble could potentially arise if a manager provided Form PF to a relatively unsophisticated client or non-US clients that are unfamiliar with US regulations.”

A second argument advanced by managers reluctant to disclose the contents of Form PF and other regulatory reports is that it could lead to proprietary data being disclosed to the market, inadvertently or otherwise. That, they say, could expose their funds to the performance-sapping risks of copycat trades or squeezes on their short positions. This seems improbable. It is a material risk for managers with long-dated or illiquid positions only, since the data will have aged by up to a maximum of 60 days by the time it reaches the SEC, let alone end-investors. In the case of managers running less than $150 million, the data is only submitted annually, so the likelihood of copycat trades or short-squeezes is even lower. Theoretically, a shrewd investor could back-date trades, although this is also improbable. So far, the information requested in all of the regulatory reports contains little position-level data, since their main focus is counterparty and systemic risk management.

A third concern expressed by managers about regulatory report disclosure to investors is legal risk. If managers show regulatory reports to select investors only, or show more of a report to some investors than others, they could be accused of favouring certain investors over others, and get sued as a result. Even supplying a redacted version of Form PF is fraught with potential regulatory as well as legal difficulties. Managers must ensure that the redacted versions do not misrepresent anything to any investor. Furthermore, disclosure to some investors rather than all might provoke awkward questions from the SEC about why the manager chose to favour some investors over others.

There are legal and regulatory risks for investors as well as managers. If a select investor received a regulatory report on an exclusive basis and identified something sufficiently worrying to prompt a redemption, and a fraud or blow-up subsequently ensued, that investor could be subject to litigation from other investors to claw back some or all of the loss that is averted. Similarly, another investor or intermediary acting for third party investors – such as a fund of hedge funds – that failed to spot the worrying piece of information in the same regulatory report could find themselves being sued by beneficiaries or end-investors for the losses incurred as a result. The litigation which followed the Madoff defalcations set an uncomfortable precedent for litigation of this kind. Feeder funds that invested in the Ponzi scheme were sued successfully for negligence and breach of fiduciary duties.

The pressure from investors for disclosure of Annex IV submissions, unlike disclosure of Form PF, is mitigated by the fact that the AIFMD insists managers make continuing as well as initial disclosures to their underlying clients. Much of this information – such as details about the investment strategy, the use of leverage and the arrangements by which collateral is posted – is already disclosed in prospectuses and offering memorandums. Much of the other information which AIFMD wants mangers to disclose, such as historical performance and up-to-date Net Asset Value (NAV) calculations, is scarcely contentious, since it will generally appear in marketing materials anyway.

However, some of the proposed disclosures will concern managers. A Carne Group guide for managers of AIFMD-compliant funds, published in 2014, says that managers must disclose to investors details of the risk profile of the fund, the percentage of assets subject to special liquidity arrangements such as side-pockets, a description of the risk management systems used, information on current and maximum leverage, and any re-hypothecation arrangements with prime brokers. In addition, says the Carne Guide, the manager must provide an annual report and supply it to investors as well as regulators. Although much of this data is readily available, and unlikely to add much to the understanding of investors, there is concern that it will sow confusion, especially if there are contradictions between the regulatory and investment reports.

One solution for managers concerned about such contradictions is to endorse the Open Protocol Enabling Risk Aggregation (Open Protocol) reporting form developed by Albourne Partners. “The objective of Open Protocol is to align disparate data sets in one place and simplify risk reporting,” says Gaurav Amin, head of risk at Albourne Partners. “The benefit of Open Protocol versus regulatory reports is that the former looks at systemic risks and other risks, while Forms PF and CPO-PQR assess just systemic risks.” In theory, investors can be directed to an Open Protocol report as the most appropriate and best contextualised account of what is going on at a fund. Amin says investors do not have to be Albourne clients to see an Open Protocol report, since any investor can demand the data from a manager.

Investors have proved hard to excite on the question of seeing regulatory reports submitted by their managers, although funds of funds and others with ODD teams are understandably keen to see as much information as they can obtain. Even then, it is highly improbable that a manager would lose an allocation or suffer a redemption for refusing to supply an investor with a regulatory report such as Form PF or Annex IV, though it will be hard to resist if the costs of completing the form are being charged to the fund rather than the management fee. The best way for managers to overcome their fears of regulatory information being misunderstood by investors is to direct inquiring investors to an Open Protocol report. It specifically aims, after all, to assess the risks of a manger from the point of view of an investor.