Transparency refers to the degree of disclosure an investment manager provides to their investors. Investors may require transparency regarding the actual trading positions and leverage of the fund, the trading strategies employed by the fund, and the pricing, accounting, and risk management processes of the fund.

A completely transparent hedge fund may manage separate accounts, where all assets are held in the investor’s trading account. This allows investors to see all positions and trading activity in real time.

The transparent fund will clearly answer detailed questions about their trading strategy and allow investors to audit their trading and risk management processes and settlement procedures.

A partially transparent hedge fund may prefer not to manage separate accounts, and may only offer investments in commingled funds. The manager of this fund may describe the spirit of the trading strategy, while concealing the exact details of the process that generate the trades. The fund may offer investors aggregated data rather than the specific positions and trading activity of the fund.

These aggregated risk reports will typically include statistics regarding the size and diversification of positions and the distribution of assets by market. Risk statistics within each market may also be disclosed, such as the average beta, sector weights, and the distribution of market capitalization for an equity portfolio.

The manager will typically allow investors to view their operations if that is a requirement of receiving a new investment, but the exact algorithms used to generate trades or risk management processes will not be disclosed. Performance is disclosed only on a monthly basis, and the returns of the fund are audited on an annual basis .

In order to reduce operational risks , it is important that these performance estimates and aggregated risk statistics come from the prime broker or the third party vendor of a risk management system. Should a manager have fraudulent intentions, performance or position data disclosed by the fund may be changed to conceal the true risks or performance of the fund.

An opaque fund is one that offers little to no transparency to investors. This fund manager will only disclose monthly performance, and sometimes may not pay for an annual audit. Trading strategies and positions are only discussed in broad terms, and are never disclosed in full.

These funds, especially when there is a quantitative nature to the process, are often called "black box" funds, as it is difficult to see inside the manager’s process. Institutional investors are often uncomfortable with funds that lack transparency, as it is difficult to ascertain the risk of the strategy and the skill of the manager.

Investors require transparency of their hedge fund managers to become comfortable with the manager’s strategy during the due diligence process. Ideally, the manager will disclose enough about their trading process for the investor to determine the skill level of the manager before an investment is made. Transparency is also valuable to investors during the risk management and portfolio construction processes.

Investors desire that their hedge fund portfolios have a low correlation to traditional investments, as well as a low correlation between the hedge funds in the portfolio.

Access to position level, or aggregated risk statistics, for the fund allows investors to clearly see the correlation between the fund managers in their portfolio. Once an investment is made in a hedge fund, transparency allows the investor to continue to monitor the progress of the fund.

Should the fund manager choose to increase risk or leverage or modify the types of securities traded, an investor with a reasonable level of transparency would notice this divergence quickly, which allows them to have a timely conversation with the fund manager if they are concerned by these changes.

At that time, the investor may ask the fund manager to reduce risk or return to the original trading style. If the investor is not satisi ed with the response of the fund manager, the investor may choose to reduce the investment in that hedge fund to reduce the risk.

A fund of funds manager may wish to have complete transparency of the underlying positions to aggregate all of the positions of the fund to see the exact portfolio.

This helps the fund of funds reallocate capital between their hedge fund managers. Some funds of funds may implement hedges at the port folio level when the aggregated risk of their fund investments exceeds a predetermined level.

Hedge fund managers may wish to limit the degree of transparency to investors for many reasons. The most common reason cited by managers is that their positions and their trading processes are proprietary, and that disclosure would reduce the value of the hedge fund management company.

Should this information be disclosed to active traders or those who wish to profit at the hedge fund’s expense, position level data in an illiquid market can, indeed, reduce the returns of the fund by increasing trading costs.

However, the vast majority of investors and funds of funds do not have any interest in replicating the strategy of the fund or increasing the trading costs of the fund.

Fund managers may be more wary of sharing their positions with their prime broker, especially if there is not a clear separation from the proprietary trading desk. Hedge funds may also decline to offer full transparency, as the amount of information may be over whelming to investors.

If a fund executes thousands of trades each month and holds hundreds of positions at a time, this information may be difficult for an investor to interpret. Partial transparency, including a monthly summary of portfolio risks, may allow investors the information they need, while reducing the privacy concerns of the hedge fund manager.