Several index providers have come onto the market to compare and contrast the performance of hedge funds. Are they a useful benchmark for investors?
Following the growth of the hedge fund market over the past decade, several index providers have responded by introducing products designed to measure and analyse this market.
The role and effectiveness of these indices are hotly debated throughout the industry. In particular, whether hedge fund indices can be used as performance benchmarks, when hedge funds generally aim for absolute rather than relative returns?
And can hedge fund indices provide useful information on the marketplace, when the characteristics of individual funds are often specific to a particular manager?
While these questions are still being debated, hedge fund indices undoubtedly provide an extremely useful role in providing a framework for analysing and organising market information, for example, in comparing the performance of funds that have a similar investment strategy.
the role of indices
Recent developments have included the launch of investable hedge fund indices, which, their backers hope, will open up the market for a range of new index-based financial products.
Whether you are a critic or an endorser of these indices and their related financial products, you cannot ignore that they now play a role in this rapidly developing area. What is interesting is looking at the nature of their role.
Broad hedge fund indices and databases generally aim to contain the largest number of funds across the widest range of investment strategies. These broad-based indices, and their related databases of information on individual managers, are used to provide a framework for analysis and peer group comparison.
Central to these indices are the classification standards (see table) that index providers have designed to create an organisational framework for classifying funds into strategies.
A framework such as the classification structure (see table) enables calculation of indices at a general level - for example, covering the entire marketplace - or with a much greater level of granularity, for example, to measure the performance of long-biased funds investing in North American equities with a concentration in the financial sector.
Hedge fund indices, therefore, can be used to identify the drivers of performance among funds with a similar investment process and, in doing so, provide additional insight and transparency to the hedge fund market.
Broad-based hedge fund indices are generally used for purposes of research and analysis rather than as performance benchmarks, in the way that equity indices are used in investment mandates to specify expected performance objectives.
While broader indices provide the basis for analysis of hedge funds, a more recent development has been the launch of investable hedge fund indices.
These investable indices will lead to the creation of financial products such as funds, derivatives and structured products whose performance is linked to or based on the index returns. These products might be used, for example, to gain exposure to a diverse range of hedge fund strategies or to control market risk.
Such products might include index-tracking vehicles used as a simple way to gain exposure to the hedge fund market or capital protected products, which enable risk adverse investors to access hedge fund investing while limiting exposure to capital.
Investable hedge fund indices require a much higher level of liquidity than has traditionally been available to hedge fund investors. For example, the funds in the MSCI Hedge Invest Index have weekly liquidity as compared to monthly or quarterly liquidity that might be typical of hedge funds generally.
High levels of liquidity, sets index-based products apart from traditional hedge fund investments. Frequent liquidity is expected to facilitate the development of a wide range of financial products and new tools for use in portfolio management.
For investors to replicate the returns of an investable index, they must be able to access the underlying constituent funds in the index.
The lack of open public markets for transactions in hedge funds, and the discretion that a hedge fund manager has to limit capacity, would seem to put significant obstacles in the way of the development of investable indices. Index providers have overcome this challenge by applying an index construction methodology to the available funds from a specific "fund platform".
Investors can access the underlying constituent funds in the index due to the common access and liquidity terms negotiated by the platform provider. So long as the platform contains a large number of funds, spread across many hedge fund strategies, an index can be built that contains a meaningful level of diversity across a representative range of hedge fund strategies.
The relationship between the index and the fund platform has important implications for hedge funds themselves.
Before a fund can be considered for inclusion in the index, a fund has to first negotiate with the platform provider and conform to their liquidity, capacity and due diligence requirements. Subsequently, if a manager is no longer willing to participate on the platform or has no available capacity it would be removed from the index.
Additionally, platforms based on managed accounts, allow the platform provider to establish a pre-agreed investment mandate with the hedge fund manager that specifies investment restrictions, and leverage limits against which the manager can be monitored on a frequent basis.
This risk monitoring function may provide a level of comfort to investors and also permits the platform provider to value the index constituent funds independently of the hedge fund manager.
One of the questions often raised regarding investable hedge fund indices is whether they can be a representative measure of an industry that contains many thousands of funds.
One response is to compare the objectives of investable hedge fund indices against the broader hedge fund indices.
While the broader indices are designed to achieve maximum representation of the hedge fund market, the investable indices aim to balance representation with liquidity. The emphasis on liquidity for investable indices will inevitably mean far fewer funds are available for inclusion in an investable index compared with the total number of hedge funds in existence.
An investable index can still represent the structure of the hedge fund industry by including funds from a range of strategies weighted according to the importance of each strategy in the market (see graph).
Indeed the issue of how to weight strategies in a useful investable hedge fund index is an important issue. Two alternative weighting approaches, equal or asset weighting are generally taken by index providers.
Equal weighting of funds, results in a weighting of strategies according to the number of funds in each strategy. Asset weighting is similar to the market capitalisation approach of some equity indices, using fund assets under management as the driver of index weights. Both of these approaches have their benefits and weaknesses.
Equal weighting can over-represent strategies where low barriers to entry for a new hedge fund manager may result in a large number of small funds.
Asset weighting, on the other hand, seems more logical, but may result in skewed strategy weights due to the inclusion of a few large funds in a particular strategy. A third approach adopted by S&P is to give an equal weight to strategies, which has the advantage of simplicity but may not reflect the structure of the general marketplace.
The weighting approach, developed by MSCI, aims to reflect the importance, that is weight, of each strategy in the universe by looking at the median assets of funds within each strategy. This method balances the equal and asset weighted approaches and reduces the impact of a single large manager in the index.
The development of investable hedge fund indices is still at an early stage but early signs indicate the availability of such indices is likely to have an important impact in the marketplace. Investors looking to gain exposure to hedge funds or who desire products that provide some form of capital protection through the use of derivatives, may be interested in the many types of such products that will be launched.
Hedge fund investors themselves, including fund of funds managers, may wish to use liquid index-based products alongside direct hedge fund investments to maintain full market exposure and yet be able to respond quickly to inflows or outflows of investments from their portfolio. Index providers, such as MSCI and others, provide the basis for the creation of these potential new financial products.
There are serious doubts about the ability of index providers to produce hedge fund products that can be used to compare performance meaningfully.
Despite the limitations of hedge fund indices, they undoubtedly give a very interesting indication about the general health and direction of the hedge fund industry.
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