On February 14, 2008 Morningstar announced the release of two new services geared to the hedge fund market.  As with mutual funds, Morningstar now rates hedge funds from one-star to five-stars, and they provide a series of indexes designed to track hedge fund performance over time.

We review Morningstar’s offering and provide our analysis of the implications for advisors.

This announcement represents a significant step in a four-year effort by Morningstar to become a leading hedge fund data provider.  In August of 2006, Morningstar acquired the Institutional Hedge Fund database division of InvestorForce, which included the Altvest database, at the time one of the largest hedge fund databases.  In March of 2007, Morningstar acquired Standard & Poor’s Fund Data Business, which included a database of hedge funds.  Morningstar has unified these offerings, and now maintains a database of approximately 7,700 hedge funds, of which 3,300 are funds of funds.  In 2007, Morningstar introduced its hedge fund categorization system, and began releasing statistics on hedge fund performance based on the data they maintain.   

Only the 4,400 direct funds are eligible for ratings and inclusion in the indexes, and only a subset of these have the 38 consecutive months of return history necessary to receive a rating.  Funds of funds are not rated or included in the indexes because Morningstar has not yet developed a scheme for their categorization. 

Funds report their data (e.g., returns, NAVs, assets under management) directly to Morningstar on a monthly basis.  All data is reported net of fees.

The new offering is significant in two respects.  First, by rating hedge funds in a fashion similar to mutual funds, Morningstar provides a clearly calibrated yardstick for comparisons among funds and specifically between funds with similar strategies.  Second, by publishing indexes, Morningstar facilitates the analysis of performance across the hedge fund industry, and provides the basis for creating tradable securities based on these indexes.

Detailed information about Morningstar’s offering is available here.

Hedge Fund Ratings

Morningstar assigns each fund to one of 17 different strategies (listed below), based on an analysis of the fund’s historical returns, as well as interviews with fund managers and a review of the offering prospectus.  To receive a rating, there must be at least five funds in the category to which it is assigned.  All categories currently meet this requirement, with the smallest category having 44 funds.

Morningstar provides full documentation for the calculations they use.  A utility function is used to calculate risk-adjusted return, similar to the methodology used for mutual funds, but different in two respects.  First, the returns are “unsmoothed” to remove first order serial correlation.  This is necessary because many funds invest in illiquid securities, which give fund managers “flexibility” in how they value funds and report returns.  The “unsmoothing” technique is designed to expose the underlying risk characteristics of these holdings.  Second, the utility function adjusts for the fact that hedge funds have non-normal returns.  Hedge fund returns do not follow a bell curve pattern; they have “fat tails” which reflect a higher probability of abnormally low returns (i.e., “blow ups”).

Funds are ranked based on risk-adjusted return, and a star rating is assigned using the same bell curve distribution as with mutual funds (the top 10% are assigned five stars, the next 22.5% four stars, the next 35% three stars, the next 22.5% two stars, and the last 10% one star).

Hedge Fund Indexes

In addition to rating hedge funds, Morningstar has created an index of the hedge fund industry (the Morningstar 1000 Hedge Fund Index), as well as 17 individual indexes that track the performance of the 17 strategy specific hedge fund categories.

The Morningstar 1000 index is equally weighted (i.e., each fund is given equal weight in the index, regardless of the size of its assets).  The index consists of the funds comprising the top 90% of assets in the Morningstar universe.  Excluded from the index are funds of funds and funds that fail to provide returns twice in a 12 month period.  In cases where a fund has multiple share classes, the share classes are combined and treated as a single entity.  Indexes for the 17 sub-categories follow the same procedure, constituting the top 90% of assets in each sub-category.

Index values are reported monthly, with a final value reported a month following the end of the month.  Interim values are reported during the month.  Indexes are rebalanced monthly and reconstituted quarterly.

Morningstar provides the historical data below, showing the comparative performance over the recent bull market:

The data above shows hedge funds providing equity-like returns with roughly half the volatility of the S&P or MSCI indexes.

Below are the annual returns and standard deviations for the 17 hedge fund categories and for funds of funds.  This data is for the six year period 2002-2007.

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