Two rating agencies, Moody's Investors Service and Morningstar ( MORN), plan to launch divisions early next year to evaluate hedge fund risk and performance. The initiatives come amid a period of relative glasnost within the secretive industry. Starting in February, the Securities and Exchange Commission will require most hedge fund advisers to register with the agency and subject themselves to random audits. "We're hoping to create a rating system by the end of the first quarter," says Morningstar analyst John Reckenthaler. He works for Ryan Tagal, who heads up a hedge fund database group launched by Morningstar last year. With hedge funds getting more popular, and with horror stories of fraud occasionally seeping into the public's consciousness, wealthy and institutional investors alike are demanding more transparency. "Investors want it," says Lisa Tibbitts, a Moody's spokeswoman. "There is a demand for it, especially in the context of very visible and high-profile failures as well as the changes with the SEC." While the launch of the Moody's and Morningstar projects happens to coincide, their approach is different. Moody's plans to focus on the operational risk of funds, looking at things like the liquidity of their investments and quality of management. Morningstar is likely to rate funds based on their performance, as it already does for mutual funds. Another key difference is the customer. In Moody's case, hedge funds will pay for the service, the way debt-issuers pay both Moody's and S&P for opinions on their bonds. At Morningstar, investors will foot the bill. "We are going to look at the downside risk: what is the likelihood that something really wrong would happen?" says Moody's Gary Witt, who has been heading the project. Witt says his group is reviewing a list of 50 hedge funds that have run into trouble due to bad valuations, poor auditing, shoddy administration and other factors.
Eventually, Moody's also will study the relationship between the hedge funds it rates and the companies that service them. Such providers won't be directly rated, Witt says, but Moody's will have "internal opinions" on them, he says. Putting together a rating service is a complicated process. The first step was to collect data. Last year, Morningstar launched its own hedge fund database. Moody's doesn't own a database but subscribes to HedgeFund.net. While the discipline of fund ratings is new to Moody's, the agency's familiarity with managed-fund dymanics as they exist in collaterlized debt obligations makes it easier. Witt cliams the new division's business model -- with funds paying for ratings -- doesn't necessarily imply conflicts of interest. Still, funds that are likely to fare poorly might be less inclined to become customers. "We can't force anyone to be rated," Witt says. "People who feel they'd get a good rating would be more motivated to get a rating."