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  HOME > HEDGE FUND INDEXING—A SQUARE PEG IN A ROUND HOLE?


 
 Hedge Fund Indexing—A Square Peg in a Round Hole?
 
INVESTMENT INSIGHTS - June 2003

By Adele Kohler, CFA,
Principal and Portfolio Manager of the Global Structured Products Group


Hedge Fund Indexing: A Square Peg in a Round Hole?


Abstract

Hedge funds have become increasingly popular among institutional investors due to their potential for generating positive returns in any market environment. However, significant effort is required to evaluate, select, and monitor hedge funds. The universe is expansive and dynamic. Hedge fund managers are notoriously guarded when it comes to publishing details about their strategies and limited regulation has resulted in inconsistent levels of disclosure.

Hedge fund indices have emerged as a tool to aid investors in implementing and monitoring hedge fund investments. We outline the theoretical and practical challenges of applying an index-based approach to an active manager universe.

Table of Contents
 
Introduction
Background on Hedge Funds
Getting Exposure
Theoretical Shortcomings of Hedge Fund Indexing
Practical Challenges of Hedge Fund Indexing
Conclusion
Appendix A: Real-Life Example
Appendix B: S&P Hedge Fund Index Methodology



Introduction
Hedge funds have become increasingly popular among institutional investors due to their potential for generating positive returns in any market environment.

Given the dismal performance of most global equities over the past three years and the meager yields of most fixed income instruments, plan sponsors are more determined than ever to unravel the mystery that has shrouded the hedge fund universe. But it isn't easy. The hedge fund universe is expansive and dynamic. Hedge fund managers are notoriously guarded when it comes to discussing their strategies or revealing their holdings. And they often change their approach depending on market conditions. As a result, significant effort is required to evaluate, select, and monitor hedge funds.

Certain methods have arisen to aid investors in navigating the hedge fund waters. Hedge funds-of-funds offer professional fund selection and consistent reporting across several hedge fund investments.

Recently, hedge fund indices have emerged as a tool to aid investors in implementing and monitoring hedge fund investments. In this paper, we explore the various methods of gaining exposure to the hedge fund universe. We then address the validity of indexing in this area, discussing both the theoretical implications and the many practical issues associated with implementing this approach.

We arrive at several conclusions: first, hedge fund indices provide a valuable service in attempting to measure performance, clarify hedge fund strategies, and extract some level of transparency from the industry. However, their success in doing so varies significantly from one index provider to another, and is a function of both index methodology and, more importantly, the diverse, dynamic, opaque, and fractured nature of the hedge fund universe. We discuss the challenges of maintaining an index that accurately portrays and measures a universe of investments that, to some extent, defies measurement.

Second, there are both theoretical and practical barriers to implementing an index approach in the hedge fund universe. Practically speaking, hedge fund indices are difficult to create, maintain, and replicate. Also, there are challenges to creating investable, liquid vehicles for investors even when a viable index is identified. In addition, while Modern Portfolio Theory provides a solid theoretical justification for passive investment in the “market portfolio' of investable securities, there is no theoretical rationale for applying a passive investment approach to an active manager universe, be it a universe of traditional active managers or hedge fund managers.

While some of the practical hurdles can be overcome, we believe that the concept of indexing a manager universe is inherently f lawed. It ignores the central goal of passive investing which is to capture the unique capital allocation function of a market portfolio determined by market prices.

Third, despite the lack of theoretical underpinnings, hedge fund “index' products do exist, and continue to proliferate and evolve. These products may appeal to investors because they address some of the most problematic elements of hedge fund investing. We will describe the potential benefits and drawbacks of investing in these products and explain why hedge fund index products are more closely aligned with active funds-of-funds than traditional index funds.

Background on Hedge Funds

To better understand the challenges of investing in hedge funds, and the reasons why hedge fund indices and index products have evolved, we must first understand both the evolution and the nature of hedge funds themselves.

What Is a Hedge Fund?
A hedge fund is a private investment portfolio –– usually a limited partnership, managed by a general partner and open only to accredited investors. To classify as an accredited investor, one must meet specific income and wealth requirements. Most hedge funds are limited to 99 investors1 and therefore will often impose very investment insights june 2003 page 2 investment insights june 2003 page 3 high minimum investment requirements, typically ranging from $100,000 to $5,000,000. Due to their legal structure, hedge funds are not subject to many of the investment restrictions and reporting requirements imposed on mutual funds and other investment vehicles. As a result, hedge funds have a broad variety of investment instruments and techniques at their disposal including options, futures, short selling, leverage, and risk arbitrage. Typically hedge funds are managed by the general partner, who will often invest his or her own capital in the fund. Investors are usually charged a management fee as well as an incentive-based fee equal to 20% of the profits.

Hedge funds are distinguished by their legal structure and resulting investment freedom as opposed to any common investment theme. The unrestricted nature of hedge fund investments makes the collective pool of hedge funds extremely diverse. While there is no official classification standard, there are several broad categories commonly used to describe the investment methods of various hedge funds.

These include, but are not limited to: convertible arbitrage, distressed securities, emerging markets, long/short equity, event-driven, fixed income arbitrage, global macro, managed futures, market neutral arbitrage, market timing, merger arbitrage, opportunistic, relative-value arbitrage, sectors, short selling, statistical arbitrage, and funds-of-funds. It is important to note that these categories in no way define the level of risk or the return objectives of the underlying funds, but merely the nature of the strategy itself. With so many techniques, objectives, risk levels, and investment vehicles used by hedge fund managers, it is a wonder that these portfolios can be considered by some to be part of the same investment category. The one common factor among hedge funds is that most, but not all, attempt to provide an absolute, positive return stream that is independent of market returns.

Growth in the Hedge Fund Industry
Hedge funds have enjoyed rapid growth over the past decade.

Assets invested in these strategies have increased from approximately $25 billion in 19902 to nearly $600 billion today.3 Some industry projections show hedge fund assets reaching $1 trillion by 2004.4 The limited regulation in this area and low barriers to entry have ensured a ready supply of new funds since virtually anyone can start a hedge fund. As was the case with mutual funds about a decade ago, the number of hedge funds nearly exceeds the number of the securities on the New York Stock Exchange. While there are over 6,000 funds in existence today, that number could grow to over 9,000 funds by 2004.5 The tremendous growth in the hedge fund industry is making it more difficult for sophisticated investors to ignore this class of investments.

Many institutional investors have at least begun to contemplate an allocation to this area.

What Is Driving the Growth in Popularity?
Several factors have contributed to the explosive interest in hedge fund investing. Investment minimums have come down, reducing the exclusivity of these products. While minimums once ranged from $500,000-$5,000,000 just a few years ago, many funds now require between $100,000- $250,000 and even less in some funds-of-funds.

Correlations*

CSFB/Tremont Hedge Fund Index (HFI)6

S&P 500

0.38

MSCI EAFE

0.47

Lehman Aggregate

-0.07

Citigroup Non-US 5+ Year Government Bond Index

-0.18

*Based on returns from 1/1998-3/2003. Source: Ibbotson



Three consecutive years of negative equity returns, high volatility, uncertain earnings growth, globally depressed cash and bond yields, and high-profile debt defaults have sent investors searching for alternatives to traditional asset classes like stocks and bonds.

Hedge funds, as a group, have exhibited fairly low or negative correlations with these markets and have, on average, produced positive returns in recent years.

Greater sophistication among investors and the growing acceptance of the hedge fund market as an asset class have resulted in more endorsements by the consultant community. Many consultants now regularly recommend an allocation to hedge funds for their clients. Today a much higher portion of hedge fund inf lows is coming from institutional sources. Ten years ago, the hedge fund market received close to 80% of its investments from high-net-worth individuals.

In contrast, almost half of all new investments now come from institutional investors.7 Some large pension plans have begun to test the waters with allocations to hedge funds ranging from 0.75% to 46% of plan assets, as illustrated in the table above.

Getting Exposure

Individual Hedge Funds
Investors are drawn to hedge funds because they offer a unique combination of attributes. First, as mentioned above, because a portion of the fees are performance-based, when the fund loses money, investors incur only the fixed management fee. Second, hedge funds provide opportunities to generate alpha (value added in excess of risk-free return) in any market environment. Also, hedge funds can serve as additional sources of diversification, lowering overall portfolio risk, and/or increasing returns. Because there are so many hedge funds, investors can select from a seemingly endless assortment of approaches and risk levels to suit their needs.

On the other hand, the dizzying array of choices can often leave investors guessing as to which funds will serve as appropriate additions to their overall portfolios.

And, since hedge funds are not held to the same stringent reporting standards as other types of investments, it may be difficult, in some cases, to get a clear and accurate explanation of a fund's objectives, risk level, and track record. Some hedge funds invest in securities that do not achieve regular price discovery. Therefore, even when net asset values (NAV) are forthcoming, they may not accurately depict the true value of the investment at any point in time due to stale or purely theoretical pricing. And, on occasion, hedge fund managers have been known to alter their approach without divulging the change in strategy to their investors.

The general lack of transparency in the hedge fund marketplace makes fund selection and monitoring a challenge.

Conducting proper due diligence is difficult and time-consuming. For some investors, the time and resources needed to thoroughly investigate, select, and monitor managers outweigh the benefits of investing in this area. Institutional investors are particularly vulnerable to this tradeoff due to their important role as fiduciaries and the ongoing pressure to keep staffing levels low.

Annualized Returns

CSFB/Tremont HFI

S&P 500

MSCI EAFE

Lehman Aggregate

Citigroup Non-US

Through 3/31/2003

       

5+ Year Gov. Bond Index

One Year

4.60%

-24.76%

-22.94%

11.69%

33.05%

Three Years

3.46

-16.09

-19.29

9.81

7.81

Five Years

5.85

-3.77

-6.85

7.51

6.94

 Source: Credit Suisse First Boston (CSFB)/Tremont and Ibbotson


Hedge Funds-of-Funds
The recent emergence of hedge funds-of-funds has helped to address this significant barrier to investing by off loading at least a portion of the due diligence process.

By performing their own research on available hedge funds, narrowing the field, and providing their professional insight regarding which funds to choose, funds-offunds have essentially transferred from investor to manager a very costly and resource-intensive aspect of investing in hedge funds.

This feature has successfully attracted investors who might otherwise have forgone a hedge fund allocation. These vehicles have several other appealing characteristics: they offer a diversified pool of hedge funds, they allow access to a broader selection of top funds that might otherwise be unavailable due to high investment minimums or manager-defined capacity constraints, and they offer consistent reporting across each hedge fund investment. In addition, funds-of-funds managers perform crucial monitoring and oversight of underlying funds as well as managing hedge fund styles within the portfolio. They also offer skills in moving from one hedge fund style to another depending on market conditions.

The growing demand for funds-offunds leaves little doubt that investors are looking for ways to share the due diligence burden.

“Estimated assets in hedge fundsof- funds doubled between the end of 2001 and the end of 2002.

Inf lows into fund-of-funds strategies reached $103 billion in 2002 –– more than five times that of 2001. There are an estimated 781 funds-of-funds today –– 42% more than there were in 2001.'8 The fund-of-funds structure is not without drawbacks however. For one thing, fund-of-funds managers charge a fee above and beyond those imbedded in the underlying investments, and in some cases may include a performance fee at the fund-of-funds level. Therefore, the performance hurdle ––the positive return requirement to offset costs –– of the underlying hedge fund investments is even higher under this arrangement. And, while due diligence on the hedge funds themselves is reduced, investors are still faced with the managerselection problem at the fund-offunds level.

Investors may find the process of picking good fund-of-funds managers just as challenging as picking hedge funds themselves.

Funds-of-funds are subject to the same performance persistence issues as are individual hedge funds and other active approaches.

Top-quartile performers in one year often find themselves in the bottom quartile in subsequent periods.

CSFB/Tremont reports that of the 48 funds-of-funds in the top quartile of the TASS database at the end of 1997, only 16 remained there at the end of 1998. Five funds remained in the top quartile through 1999 and by the end of 2000 only one remained in the top quartile. Twelve of the 48 original funds actually dropped to the bottom quartile after the first year.9

Hedge Fund Indexing

An alternative to the fund-offunds option is the latest evolutionary step in hedge fund investing –– hedge fund “indexing.' While there are only a few indexbased hedge fund products in operation today, the interest in this approach is steadily increasing as both investors and practitioners examine its viability.

Indexing has long been an ideal method of achieving broad-based, low-cost, efficient exposure to global equity and bond markets. So it is only natural that investors would seek to employ this approach across the full range of their investments. Additionally, the application of index investing appears to be an ideal way to off load much of the research costs associated with hedge fund investing without adding a layer of manager selection, monitoring, and fees. This is because hedge fund indexing uses an index provider's representation of the market as the basis for constructing a portfolio rather than relying on a fund-offunds manager to handpick hedge funds deemed worthy of inclusion in a portfolio.

At first glance, indexing appears to be the next logical step for institutional investors seeking an efficient way to gain exposure to the hedge fund market. However, upon further examination, investors will find that the concept of indexing cannot easily be applied to the hedge fund universe for both theoretical and practical reasons.

Theoretical Shortcomings of Hedge Fund Indexing

Some proponents of hedge fund indexing assume that indexing is simply a portable implementation method, which can be applied to any group of investments, regardless of whether those investments constitute a true asset class. They assume that passive investing is merely a means of achieving average performance results. But while index investors strive for the weighted-average return of all market constituents, it is with the belief that this “average' return represents a unique equilibrium investment solution. The benefits of achieving that average can only be derived in the context of a true market portfolio where assets are priced by market participants.

The market portfolio consists of all claims on companies ––the primary wealth-producing entities in the economy. These claims , whether stocks or bonds , experience regular price discovery. And these prices ref lect expectations for risk and return. Therefore, by owning each claim or security according to its capitalization weight, investors arrive at the optimal combination of assets. Theory suggests that by owning this specific combination of assets, investors can expect the optimal risk/return tradeoff and achieve the return premium associated with the asset class.

However, outside of a true market portfolio, there is no rationale for achieving the “average' return.

Indexing in the hedge fund manager universe is not an optimal solution because the hedge fund universe is not a traditional asset class. A key defining feature of assets within the market portfolio is that they are priced by market participants to ref lect their value.

Hedge funds are a collection of investment positions, but are not an asset class per se, because the critical capital allocation role of the market's price discovery function does not occur. Rather, hedge funds are a subset of the total active manager universe –– a collection of active manager skill levels. These skill levels are not claims on wealth-producing assets. They do not achieve regular price discovery.

(While asset f lows into and out of hedge funds can be considered a vague indicator of manager popularity, they by no means constitute a functioning liquid market.) Also, they are not associated with any expected return level. As a result, there is no clear way for investors to allocate among hedge funds in the context of a passive portfolio.

Neither equal weighting nor asset weighting is a direct ref lection of expected risk and return information imbedded in the funds.

No matter how you arrive at the “average' return of the hedge fund universe, the result is not a market-determined average but an arbitrary effect of a subjectively chosen weighting scheme.

In attempting to index this universe, investors are abandoning the rationale for being there in the first place, which is to capture pure alpha or above-market returns generated in an unconstrained environment by skilled hedge fund managers. As with any active manager universe, not all hedge fund managers are successful and manager selection is critical. Why then would investors want to diversify away the alpha-generating capability of one manager in order to get exposure to other, unskilled managers? Investors should no more want to index the hedge fund manager universe than they would any active manager universe. As tempting as it is to apply the simple capital allocation benefit that comes from passive investing to the complicated hedge fund world, the concept simply does not apply. Therefore, results may be disappointing for hedge fund investors.

Practical Challenges of Hedge Fund Indexing

For some investors, the lack of theoretical support for hedge fund indexing is not a sufficient deterrent to implementing an index-based approach. These investors must navigate a thorny path in order to arrive at an investment approach that resembles an index portfolio. The starting point for any index-based approach is of course the index itself. As you might imagine, structuring an index of hedge funds is no easy task. The hedge fund universe is dynamic and elusive. Nevertheless, there are a surprisingly large number of hedge fund index families. However, each has a unique approach to both index construction and performance calculation. The differences in methodology are striking, and ref lect the unique challenges and tradeoffs that index providers face in providing viable indices in the hedge fund universe. Performance calculation is a clear example of the resource intensity required to accurately portray this class of investments.

Performance Biases
Each hedge fund index provider is faced with the challenge of creating an accurate historical return series.

Depending on the breadth of the index, this can be a nearly impossible task. Index providers must rely on hedge fund managers to voluntarily submit fund information and return data. This introduces a self-selection bias that can skew database information.

Additionally, the hedge fund universe is always changing.

Certain funds reach their funding limits and close their doors to new investors while new funds are created. Some funds change their investment approach midstream and others abruptly cease operations.

The dynamic nature of the “asset class' calls for particular attention to fund classification, timing of inclusion in the benchmark, and treatment of closed and defunct funds. Some index families attempt to address these important performance issues like fund selection and survivorship biases by including both open and closed hedge funds, keeping all funds in the performance universe for as long as the funds exist, and by refusing to alter historical performance figures when an existing fund decides to start submitting prior period returns.

The degree to which each index provider addresses these issues will have an impact on the reliability of the return series generated by the index. Survivorship rates are very low in the hedge fund world. One recent study illustrates that of all funds in existence for at least six months, 50% terminate within the next two years. The likelihood of a hedge fund existing for five years has been less than 5%.10 Without aggressively adjusting for the biases inherent in the hedge fund universe, performance information will be virtually irrelevant to any real-life hedge fund investment scenario. As an example, we looked at three different hedge fund return series designed to represent the total US-based hedge fund universe and found that not only did their return results vary significantly, but their correlations with one another were lower than one would expect from indices meant to represent the same asset class. Correlations among indices in traditional asset classes were much higher.

Institution

Hedge Fund History

Approximate Target Allocation to Hedge Funds Today

University of North Carolina

First hedge fund investment in 1990

40%

California Institute of Technology

Prior to May 2002, 3% target to hedge funds

46%

GE Asset Management

First hedge fund investment in 1991

3%

General Motors Asset Management

First hedge fund investment in 2001

1.2%

CalPERS

 

Unknown

0.75%
with possibility of increased allocation later this year

Source: Pension & Investments, March 3, 2003


Annualized

TASS

Hennessee

S&P Hedge Fund

Returns (3/31/03)

Database

Group

Pro-Forma Index*

1 Year

4.60%

-3.64%

5.33%

3 Years

3.46

0.24

8.28

5 Years

5.85

6.71

8.95

*Live S&P HFI returns from October 2002

Source: CSFB/Tremont, Hennessee Group, and S&P


Correlation**

TASS Database

Hennessee Group

S&P Hedge Fund Pro-Forma Index

TASS Database

1.00

0.84

0.67

Hennessee Group

0.84

1.00

0.66

S&P Hedge Fund Pro-Forma Index

0.67

0.66

1.00

Source: CSFB/Tremont, Hennessee Group, and S&P



These results are in part due to differences in the way the index providers adjust for survivorship.

Other inf luencing factors include the intended breadth and investability of the benchmark, the general quality of data, and the diligence applied in maintaining that data. Index providers' strengths and weaknesses in these areas result from the tradeoffs they are forced to make in this unique manager universe.

Benchmark construction involves a series of compromises aimed at providing a useful tool for a target group of investors. Very few benchmarks are targeted toward and meet the requirements of “passive' investors.

Benchmark Construction
In addition to the challenges of publishing accurate returns, index providers face competing objectives when constructing hedge fund benchmarks. They include:

« Completeness: an index should provide full representation of all available investments within an asset class

« Accuracy: pricing and performance data should be readily available, consistent, and reliable

« Transparency: index construction methodology should be clear, objective, and known in advance

« Investability: investors should be able to achieve benchmark exposure easily and continuously

« Low turnover: the benchmark constituents should be relatively stable over time with little ongoing trading required Given the universe in question, it is very difficult for an index vendor to achieve all of these goals simultaneously. For example, in order to provide a complete representation of the hedge fund market, funds that are closed to new investors should be included.

However, an index with constituents that are closed to new investors cannot be considered fully investable. The two objectives are incompatible in this universe. The following table outlines the potential barriers to creating a hedge fund index that meets the traditional requirements of a good benchmark.

Correlation**

S&P 500

Russell 3000

Wilshire 5000

       

S&P 500

1.00

0.99

0.98

Russell 3000

0.99

1.00

1.00

Wilshire 5000

0.98

1.00

1.00

**Based on returns from January 1998-March 2003

Source: Ibbotson



Because the hedge fund universe requires index providers to make tradeoffs in benchmark construction, the resulting indices vary in their objectives. Some hedge fund indices are constructed to offer the broadest, most inclusive set of hedge fund data regardless of capacity, size, or length of operation. While these indices and their corresponding historical return series serve as tools for peer-group analysis and risk assessment, they are not put forth as investable indices suitable for replication.
Other providers offer data on a narrower subset of funds with the belief that thoughtful inclusion criteria can result in an index that accurately ref lects the characteristics of the entire hedge fund universe. Like their broader counterparts, these benchmarks often include both open and closed funds making them more appropriate for peer-group analysis than for replication.
Only a small minority of index providers actually attempts to provide indices comprised of a narrow, investable, and transparent set of funds specifically designed for index investors. Below is a summary of hedge fund index providers.12 While none of these providers meets all of the criteria for a good benchmark, a few attempt to balance one criteria against another to arrive at a compromise solution for a passive-like approach. Due to their inclusion criteria, CSFB/Tremont, HFR, MSCI, S&P, and ZCM are among the indices most likely to appeal to investors attempting an index-based approach. At least three of these indices are currently being used as “passive' benchmarks for existing assets or index products under development. Zurich Capital Markets and S&P both publish narrow benchmarks with institutional investors in mind.

They both satisfy an obvious requirement for investability –– neither includes funds that are closed to new investors. This is an important factor that makes many of the other broader benchmarks ineligible for a passive-like approach. They both have stringent manager reporting requirements and they both take measures to ensure that managers are classified in the appropriate style category.

Attributes of a Good Benchmark

Challenges to Creating a Viable Hedge Fund Benchmark

Completeness

« The hedge fund universe is comprised of both open and closed funds; closed funds are uninvestable assets

« Some managers may choose not to submit data to index providers due to stringent disclosure and reporting requirements

« Multi-strategy funds usually do not get included because they are difficult to classify

« Self-selection biases may skew benchmarks toward managers of certain styles or those who need the database exposure

Accuracy

« Lack of price discovery in underlying assets

« Inconsistent, unreliable, and/or unaudited reporting by managers

Transparency

« Index construction methodology is not always clearly articulated

« Committee-based decision-making

« Underlying fund strategies are not clearly articulated

« Underlying pricing data unreliable

Investability

« Must include only open funds to be investable

« Limited capacity in funds accepting new investors

« Indices may not remove funds when they close, making some benchmark constituents uninvestable

Low Turnover

« Ever-changing hedge fund landscape may require frequent changes to the index in order to accurately reflect the asset class

« Less than 20% of hedge funds survive past five years



And, while both index families include less than 55 funds, each claims to capture the broad spectrum of hedge fund styles in such a way as to eliminate the need to include all available funds.


Index Provider

Funds in Database

Funds in Index

Includes Closed Funds

Funds Disclosed?

Start Date

Return Period

             

Bernheim

700

18

Not

No

1993

Monthly

     

Known

     

CISDM11

1300

Differs by

Not

No

 

Monthly

   

Category

Known

   

(Median Returns)

CSFB/Tremont

2600

415

Yes

Yes

1994

Monthly

Hedge Fund Research (HFR)

2200

1400

Yes

No

1990

Monthly and

           

Daily Series

Hedgefund.net

2600

2000

Yes

Yes

1979

Monthly

Hennessee Group

3000

 

Yes

No

1987

Monthly

InvestorForce (Altvest)

2700

1400

Yes

Yes

1993

Monthly

Morgan Stanley Capital

1,100

370

Yes

Subscribers

Not

Monthly

International (MSCI)

     

Only

Known

 

Standard and Poor's (S&P)

Not

40

No

Yes

2002

Daily

 

Known

         

Van Hedge Fund

5,300

1,000

Yes

No

1988

Monthly

Advisors International, Inc.

           

Zurich Capital Markets (ZCM)

750

55

No

Yes

1998

Monthly

             

Source: CSFB/Tremont with updates from vendor websites12


Implementation

The challenges for “passive' hedge fund investors do not end with benchmark selection. The implementation of a hedge fund index approach is not clear-cut. A cursory look at the main objectives of an index portfolio will reveal the unique challenges of a passive approach in this universe. The first objective is to purchase each security in the index according to its index weight or purchase a subset of index constituents to achieve index-like exposure. As mentioned above, this is not necessarily possible depending on the makeup of the benchmark, and its ongoing inclusion policies and criteria. For example, if an index vendor does not remove closed funds from its benchmark, future investors will be unable to achieve index-like exposure and may experience a different return than investors who “got in' before the fund closed. As funds continue to open, accept assets, and then close to new investors, the index becomes an increasingly difficult target to hit.

Contribution and redemption activity is also problematic.

Traditional index funds are often used as liquidity pools due to the relative ease with which investors can move into or out of them without incurring significant costs.

In contrast, certain hedge fund styles don’t offer regular liquidity.

Investment restrictions and registration requirements may prohibit portfolio managers from investing contributions quickly and easily. On the flip side, many hedge funds have “lock-up' periods during which investors are not allowed to divest. This can make it difficult to shed exposure from certain funds in order to accommodate redemption activity.

Another related objective of traditional index portfolio management is to rebalance the portfolio to ref lect changes to the benchmark. While this usually involves selling index deletions and buying additions, this seemingly straightforward transaction may not be possible in a universe of hedge funds. As mentioned, the lock-up periods and other investment restrictions make it difficult, if not impossible, to coordinate the timing of transactions with index change dates.

Timing and access issues are present in traditional index portfolios, but are often mitigated through the use of derivative or other financial instruments such as futures, swaps, exchange-traded funds, and other alternatives to the underlying index constituents.

These instruments allow portfolio managers to increase or decrease exposure quickly and cheaply, thereby minimizing tracking error and keeping transaction costs low.

But because hedge funds are not securitized investments, they do not have synthetic substitutes.13 Therefore, portfolio managers are generally restricted in their ability to easily mirror the returns of a hedge fund index through the use of such substitutes.

In addition, the hedge fund index portfolio managers have little discretion regarding the cost of acquiring index constituents.

Whereas traditional index fund managers spend considerable time and energy seeking out all sources of liquidity in order to keep transactions costs low, hedge fund index managers can only affect acquisition costs if they can negotiate the management and performance fees associated with each constituent hedge fund.

The combination of hedge fund investment restrictions, lack of liquidity, universe turnover, and lack of synthetic alternatives combine to create an extremely challenging environment for implementing a passive approach.

Despite these obstacles, both index providers and portfolio managers have attempted to provide viable solutions to these issues. S&P and PlusFunds Group Inc. have formed a unique alliance to create an investable product with an indexing f lair. S&P delivers a narrowly defined index consisting of only managers who meet stringent daily reporting requirements. PlusFunds provides the infrastructure to gather daily security-level information on each and every holding of the constituent hedge funds. In addition, PlusFunds has coordinated individual agreements with each hedge fund manager in the Index to ensure ongoing liquidity. The details of this unique approach are outlined on page 13 in our in-depth Real-Life Example.

There are two important observations regarding this example. First, S&P and PlusFunds are successful in addressing many of the aforementioned implementation challenges of indexing the hedge fund universe.

They provide an index-based investment option with stable constituents, guaranteed capacity and liquidity, transparency of holdings, and diversified exposure, all for a management fee that is lower than the average hedge fundof- funds.

Second, while the product successfully evades some of the roadblocks to implementing a passive approach in this universe, the result is distinct from a traditional index approach in several ways. Normal barriers between the index provider and portfolio are blurred. The index methodology is constrained by the reporting abilities of its constituent funds and their willingness to provide parallel investment vehicles for the index fund investors. And most importantly, the theoretical weaknesses of employing a passive approach in the hedge fund universe remain.

A Few Ancillary Benefits
Despite the fact that hedge fund indexing is not materially different in theory from traditional hedge fund-of-funds management, product development in this area has been a catalyst for several positive trends in the hedge fund industry. First, more scrutiny is now being applied to the hedge fund indices. Index providers are competing to deliver more investable, transparent, and accurate representations of the hedge fund universe. These efforts will ultimately lead to better hedge fund benchmarks against which investors and managers can measure portfolio risks and performance results. Second, the fee pressure brought about by indexbased hedge fund products should result in a new level of price competitiveness among fund-offunds providers. Finally, purveyors of index-based products are creating ways to help institutional investors bypass significant barriers to investment such as lockup periods, capacity issues, and minimum investment requirements.

As we observe in the PlusFunds product, investors are offered better liquidity, more capacity, and much more transparency than they would experience by investing in the funds directly. Institutional investors will benefit if this trend toward better access and information continues, making hedge funds more likely recipients of plan assets.

Conclusion

A thorough evaluation of hedge fund indexing should incorporate both the theoretical and practical issues discussed above. As for the practical feasibility of implementing a hedge fund index approach, we have noted the challenges related to both benchmark and portfolio construction. S&P addresses some of the challenges of creating an investable, low-turnover benchmark by significantly narrowing the universe of possible index constituents, and requiring a high level of fund transparency and accuracy in reporting. The portfolio manager in our example, PlusFunds, strikes individual agreements with the Index provider and hedge fund managers in order to provide liquidity that more closely resembles that of a traditional index fund. These examples show that it is possible to create an index-based investment product in the hedge fund universe.

As more products emerge and evolve, we will likely see many competing hedge fund models.

However, while these products may have the look and feel of a passive approach, they do not qualify as truly passive products because they are not being implemented in the context of the market portfolio. The hedge fund universe lacks certain fundamental characteristics of a true market or asset class. As a result, the average return of this universe –– even if both measurable and achievable –– does not ref lect the unique and optimal allocation of capital embodied in the average (or market) return of a true asset class.

We view index-based hedge fund products as hybrid approaches falling somewhere between indexing and fund-of-funds management. They are systematic funds-of-funds where the index provider plays a critical role in allocating capital across different funds. While some investors may prefer the purposeful, methodical, and rules-based environment inherent in this approach, they should also be mindful of the fact that the results are as subjective as those achieved through traditional fund-of-funds approaches.


Endnotes
  1. According to Van Hedge Fund Advisors International, Inc. recent changes in the law allow some funds to accept up to 500 qualified purchasers.
  2. PlusFunds Group Inc.
  3. Van Hedge Fund Advisors International, Inc.
  4. Hayashi, Yuka. 'Hedge Fund Assets Seen Rising to $1 Trillion by 2004,' Dow Jones News Service , June 19, 2002.
  5. Ibid.
  6. Credit Suisse First Boston (CSFB) Tremont Index LLC
  7. Collins, Daniel P. 'Looking for Gold,' Futures, Chicago, Futures Magazine Group Futures , September 2002: 70.
  8. Pensions & Investments , March 3, 2002
  9. CSFB Tremont Index LLC, 'Presentation to the Sixth Annual World Cup of Indexing,' February 24-25, 2003
  10. Brown, Stephen J., William N. Goetzmann, and James Park. 2000. Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry.
  11. Ibid.
  12. This is a partial list. Certain providers were omitted due to lack of published information.
  13. ©CISDM 2002. All rights reserved. Reproduced from www.marhedge.com.
  14. See note 9 above.
  15. UBS offers an S&P Hedge Fund Index bearer certificate listed in Frankfurt and Luxembourg, and denominated in euros and US dollars.


Appendix A:

Real-Life Example of an Index-Based Hedge Fund Product

Today very few off-the-shelf hedge fund index products exist, probably due to the complexities of both index and portfolio construction.

Legal constraints regarding the distribution and use of hedge fund index data are unique to each index provider and so to generalize about the implementation of hedge fund index products would be inappropriate. Instead, we explore how one index provider has chosen to construct its benchmark for institutional investors who want passive-like exposure to the hedge fund universe.

Since S&P markets its Index as a truly investable benchmark, we make the S&P Hedge Fund Index (S&P HFI) the focus of our example. Currently, S&P has entered into an exclusive licensing agreement with PlusFunds Group, Inc. (PlusFunds), a company founded to develop valuation and risk management transparency for hedge fund investors. PlusFunds’ exclusive licensing rights allow the company to launch investment vehicles designed to track the S&P HFI. The agreement applies globally and in perpetuity for all pooled investment vehicles (mutual funds, partnerships, etc.).

Therefore, the institutional investor wishing to invest in S&P HFI via a professionally managed fund must invest via a PlusFunds sponsored product.

Like a professional fund-of-funds, the PlusFunds product, called SPhinX, invests in the underlying hedge funds on behalf of its clients.

The choice of funds is, of course, a function of the Index constituents as determined by the S&P. The objective of this product is to offer broad-based exposure to the hedge fund universe at a relatively low cost and with low turnover. These are inherent features of traditional index funds. However, to achieve these objectives in the hedge fund universe, the developers of this product have employed significant structural creativity to overcome capacity issues, lack of transparency, high turnover, and other barriers to investing in hedge funds. While there is nothing unsavory about this structure, it does illustrate the complexities involved in ensuring continual access and exposure to a hedge fund index. The logistics of the PlusFunds’ product are as follows:

1. S&P selects 40 managers across nine strategies, based on quantitative criteria and due diligence.

2. S&P defines the weights for the nine strategies and the 40 managers.

3. SPhinX enters into 40 investment management agreements with the managers selected by the S&P.

4. PlusFunds sets up 40 separate accounts for these managers and allocates assets based on the S&P weights.

5. PlusFunds and its administrator value the accounts daily, and report to SPhinX investors their account value and risk information.

6. S&P determines the value of the S&P HFI based on the values for the managed accounts.

There are several noteworthy features of this structure. First, an institutional investor in this product would not invest directly in the main hedge funds of the constituent managers. Instead investors would get the hedge fund exposure via parallel accounts not subject to the same minimum investment requirements and lockup structure of the partnerships.

These accounts are managed in tandem with the main partnerships and therefore achieve similar investment results.

Second, each manager is required to guarantee a certain level of capacity. If these target capacity levels are reached, the funds may either increase capacity or S&P will add additional funds to the Index.

Funds which choose not to offer additional capacity remain in the Index. However, the overall portfolio is rebalanced, assets are directed to the new funds, and all portfolio participants experience the same performance.

Finally, the value of the S&P HFI itself is derived from the NAVs of these parallel or “managed' accounts. In other words, the accounts themselves are the Index.


As such, the traditional notion of tracking error relative to the benchmark is altered. Many of the expenses associated with investing in a passive hedge fund portfolio, like the management and performance fees charged by the hedge funds, are imbedded in the NAVs of the funds and therefore ref lected in the Index price.

Normally, the expenses associated with acquiring or selling an asset would be a source of tracking error.

Here, the only sources of tracking error would be the fees charged by the manager of the Index portfolio, PlusFunds, and any hedge fund misweights relative to the Index.

The implication of these features is that the Index itself changes based on activity within the PlusFunds product. The benchmark and the portfolio are intimately tied in a manner not found in traditional indexing. Most investors view their index provider as a separate third party whose sole purpose is to ref lect available investment opportunities and provide index data. In this case, data is exchanged on both ends. The Index vendor provides the constituent information. The manager provides the daily valuations for purposes of Index constuction as well as the data infrastructure S&P needs to monitor style drift, leverage, and other characteristics of the hedge funds in the Index. The indexing process is circular and the lines between Index provider and portfolio manager are intentionally blurred in response to the unique challenges of hedge fund investing.

Evaluation

Most index fund investors use tracking error to measure the success or failure of their index manager. Tracking error is usually a ref lection of misweights relative to the benchmark, trading costs, and fees such as custody and audit charges. Due to the unique method by which S&P creates this particular Index, many of these factors are imbedded in the Index levels themselves, reducing tracking error and making it less relevant as a measure of success.

PlusFunds managers recognize that minimizing tracking error, or providing benchmark returns, is only one aspect of the value they attempt to add to the hedge fund “indexing' process. By providing the infrastructure to capture daily valuations for all 8,000-12,000 positions in the S&P HFI, they offer a level of transparency that they believe is unique for a hedge fund product. This level of transparency sets this index-based product apart from other hedge funds-of-funds. Another distinguishing feature is the fee charged for this product. PlusFunds claims that its fees, while higher than most equity or bond index funds, are significantly lower than those charged by other fund-offunds managers. This is one feature that you would expect of an indexbased product particularly since the selection of the underlying hedge funds is a function of the index and not portfolio manager skill.

Conclusion

An investment product designed to mirror a benchmark, but not implemented in a true market, will not deliver all of the benefits of passive investing. Because the hedge fund manager universe does not constitute a market portfolio, products like the one described above should be thought of as index-based funds-of-funds.

While this labeling distinction is subtle, it highlights a fundamental requirement of passive investing –– without a market portfolio as its foundation, the average return of the funds represented in any hedge fund index is not market-determined.

Investors should be cognizant of this fact when investing in hedge fund index products.

While index-based hedge fund products do not deliver marketbased returns, some offer other benefits. Specifically, the PlusFunds product addresses several barriers to investing in hedge funds. It delivers a stable selection of investments with virtually guaranteed ongoing liquidity.

Investors are provided a level of transparency heretofore unseen in the industry. PlusFunds takes on the resource-intensive and administratively complex role of channeling investor assets into the underlying funds while making the entire transaction clean and uncomplicated for investors. And they deliver these services at a lower cost than the average fundof- funds. The challenge for investors will be to accept S&P, or any other index provider, as the determining agent for their ultimate hedge fund investments.



Appendix B:


Summary of S&P Hedge Fund Index Methodology


Objective:

The S&P Hedge Fund Index (S&P HFI) is designed to represent the broad universe of the hedge funds while delivering an investable opportunity set. The Index offers daily valuation calculations, managed account implementation, and trade verification in order to deliver maximum transparency.

Daily valuations are based on the NAVs of each constituent fund, as reported by the manager.

Constituents:

The Index consists of 40 hedge funds chosen to represent investments in three categories comprised of a total of nine specific strategies.

Inclusion Criteria:

The Index Committee determines eligibility for inclusion in the S&P HFI. Both quantitative and qualitative screens are utilized to identify funds suitable for institutional investors. Potential constituents must meet minimum requirements related to size, tenure, assets under management, managerial competence, and risk and operating controls. Additional quantitative analysis identifies managers whose strategy is deemed representative of their peer group.

Constituent funds must meet daily reporting requirements to ensure transparency. In addition, each constituent must provide a minimum investment capacity. If a fund reaches its investment capacity, it can either provide additional capacity or a new hedge fund will be added to the Index.

Index Reconstitution:

The Index is rebalanced annually in January unless special events make it necessary to rebalance more frequently. The constituents are equal-weighted initially and then rebalanced back to equal weights each January.




published by S TAT E S TREET G LOBAL A DVISORS





State Street Global Advisors, One International Place, Boston, MA 02110 _ ssga.com This material is for your private information. The views expressed in this commentary are representative of Adele Kohler only through the period ended June 2, 2003 and are subject to change based on market and other conditions. The opinions expressed may differ from those of other SSgA investment groups that use different investment philosophies. The information we provide does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. We encourage you to consult your tax or financial advisor.


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