The Hedgeweek Interview: Investable index trackers are here to stay: John Godden, Managing Director, HFR Europe

Over the past year HFR Europe has announced a string of deals with some of Europe's
leading institutions. John Godden explains the relevance of investable index trackers and
structured products to institutional portfolios.


1)  What is the background to HFR Europe?


HFR Europe was set up in 2001 to market the products of HFR Asset Management to the
European institutional investor community, bringing their technology in the area of
highly transparent, highly risk-controlled hedge fund investing which seemed to be very
well-suited to the requirements of European institutional investors.


HFR Europe is configured as an SEC-regulated fund of funds manager which uses the
HFR Asset Management Fund platform to provide bespoke funds of hedge funds for our
European clients. The amount of client activity coming into HFR from Europe has
necessitated a dedicated portfolio management team for European clients. This work is
undertaken hand-in-hand with HFR Asset Management.


The addition of the HFRX Investable Index Trackers to the HFR Group range of products
has been a significant development for HFR Europe. The demand for this product has
proved to be exceptionally strong with more than USD1 billion being placed into the
trackers so far.


2) Why are indexed hedge fund products relevant to institutional investors in
Europe?


The use of index trackers to gain exposure to traditional asset classes such as long-only
equities is now part of the institutional investment landscape. The utility of being able to
obtain exposure to a given index acting as a proxy for the returns of a given asset pool in
a cheap and easy fashion is very popular, as is the ability to capture the market beta
without exposure to the potential underperformance of making the wrong component
selection. Clearly the loss of the potential out-performance is balanced against the low
costs involved.


The new breed of investable hedge fund indices appeals to the same thinking. Investors
are able to obtain exposure to various hedge fund strategy groups without manager
specific risk, either the fund of hedge fund manager or the individual hedge fund
manager.


Investable hedge fund indices open a new gateway for investors to get exposure to hedge
fund returns. Some key barriers to entry are removed such as the double fee layer, the
costs associated with manager selection and due diligence and the risk of
underperformance.


In addition to offering a new bridge into hedge fund investing as a first step into the field,
investable indices are also being used by experienced investors to gain rapid exposure to
certain strategy areas to increase the ability of investors and funds of hedge funds to
make dynamic strategy allocations.


HFRX offers eight individual strategy indices each of which can be used separately to
provide a pure exposure to the respective strategies. Both fund of funds and institutional
investors are using these to either add flexibility to their strategy allocation programme or
to construct whole portfolios focussing on strategy allocation as a return driver, the return
of the individual strategies being defined by the indices not a pool of managers selected
in the traditional way.


The liquidity of the index trackers (all have full monthly liquidity with no limitations),
enables much more active strategy allocation to be undertaken.


3) What are the advantages to European institutions of creating structured products
linked to these indices?


The use of structured products linked to a growth asset has been an established format for
retail products and as a regulatory solution for institutions for more than 10 years now.
Until the late 90's such products were linked to equity indices, more recently we have
seen structures linked to funds of hedge funds as the low volatility characteristics of such
have been highly beneficial to the structured product buyer.


Investable hedge fund indices have allowed structured product providers to return to the
original concept of products linked to indices to create highly efficient offerings for either
retail or institutional markets. The low fee levels and the low risk attributes of the Indices
lead to lower priced structures.


The wide availability of the indices has made for an easy, more constant product
proposition for investors, structured products linked to Indices are more easily understood
by purchasers than products linked to a series of different fund of funds with different
risk, return and structural profiles.


4) How many institutions are currently creating products linked to the HFRX
indices?


There are currently six banking partners for HFRX all of which offer a wide range of
different structures from basic 'delta 1' Certificates listed in Europe through to complex
guaranteed structures and, most popular at the moment, leveraged structures.


Products have been produced to provide a risk profile similar to Treasury Instruments at
one end, and equity equivalent risk at the other.


5) What resistance or negative feedback do you encounter in Europe and how do
you tackle it?


When the investable indices were launched last April, we saw some negativity coming
from the community of funds of hedge funds. This was in part due to a fear on their part
that the indices would represent a threat to their business.


This quickly dissipated as funds of hedge funds realised that they could use these indices
themselves and, rather than threaten their position, the indices are attracting new money
into hedge funds and are aiding the level of understanding by potential investors as to the
expected return and risk profile of hedge funds.


The indices occupy a very different area to fund of hedge funds. Indices have less ability
to meet tailored risk or correlation profiles than funds of hedge funds that can meet very
specific criteria as required by certain investor types. The application of a core/satellite
approach to investing in hedge funds requires a strong funds of hedge funds sector.


A further criticism is that of the ability of investable indices to be properly representative
of the strategies they are tracking. HFR have brought 10 years of experience in hedge
fund indexation to bear in creating our investable indices. A robust methodology applied
to a full universal database enables the creation of optimal strategy representation that is
statistically strong. It is necessary to select the component managers from a very wide,
statistically accurate universe and to then apply the optimal allocation across those
components. The detailed quantitative approach to this component allocation yields a
very high level of correlation. Regular quarterly rebalancing is also necessary to retain
the integrity of the representation.


The return profiles of the investable indices since their launch have proved their veracity
and representativity to the satisfaction of many.


6) What can we expect to see from HFR Europe in the next few months?


A range of product launches based on the HFRX Indices will be announced including
some very low cost leveraged products (2x, 3x and 4x) together with announcements of
some significant distribution partners.


Our tailored funds of hedge funds business continues to be popular. New launches in
conjunction with a top global life insurer and a leading bank will add to the products
already offered with Investec, Aegon, Ferrier Lullin, Bear Stearns, Gottardo and others.

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