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A closer look at investable hedge fund indices

Investable hedge fund products are growing in popularity, says Kevin Pilarski, director of alternative strategies/derivatives, Dow Jones Indexes/STOXX Ltd.

Hedge fund index investments are estimated to have grown to in excess of USD 12 billion since the arrival of all the major hedge fund index providers over the last 18-24 months. With returns on many diversified fund of funds at or below hedge fund index returns last year, many investors are questioning the added value that an extra layer of fees provides and are turning their attention to investable hedge fund products.

While there are four or five major global index providers in the hedge fund space, there desperately needs to be a differentiation between broad-based hedge fund indices and investable hedge fund indices. Broad-based indices are fraught with many of the biases that critics of hedge fund indexation often cite, such as survivor bias, participation bias, selection bias, etc.

On the other hand, investable hedge fund indices seek to eliminate many of these biases while providing a more accurate proxy for returns on a strategy level. This, in turn, causes product construction based on investable hedge fund indices to be more efficient and creative.

In addition, investable index providers, like Dow Jones Indexes, are now supplying information that the hedge fund marketplace has urgently sought. We have endeavoured to construct accurate and reliable performance measurement tools to an industry that is evolving and expanding rapidly.

Who invests in hedge fund indices?

The efficiency and transparency that hedge fund indices provide are becoming an attractive alternative for many investors. In fact, many funds of funds are themselves now allocating to investable hedge fund indices. Much as the active equity or bond management world uses the ETF market as an equitization tool, funds of funds managers are beginning to use investable indices as a way to get exposure to a particular strategy in an efficient manner. Whether market timing or looking to deploy cash more opportunistically, these vehicles have provided an opportunity to avoid cash drag in a fund of funds portfolio.

The ability to get the inherent return from a strategy is what makes any index products attractive to investors. When you buy an equity index you expect to get the beta or systematic return from that portion of the equity world being indexed. If you buy a fixed income index, you expect the same. In the hedge fund index space, as long as your index can isolate the systematic return stream (beta) from that strategy, you can have an efficient way to get exposure to this investment style.

Many sophisticated investors have adopted a core and satellite approach to their investment portfolios where they try to capture the beta of that asset class, and then choose to seek alpha (or excess return over beta) through specific manager skill or even possibly in strategies where no reliable index is available. We are seeing more of this in the hedge fund world now that reliable hedge fund strategy indices are available.

Additionally, because certain strategies have negative or very low correlations to either equity or fixed income asset classes, investors can now invest in specific hedge fund strategy index products in order to tactically asset allocate within their entire portfolio.

The advantages and disadvantages of investable hedge fund indices

In addition, hedge fund index products offer a number of advantages over single manager investments. For example, with the exception of one of the established providers, all of the major investable indices are based on managed accounts. This means that the underlying managers provide full transparency of his/her holdings. Each and every trade may be viewed by the asset management platform and/or index provider, which in turn allows for better monitoring of style drift, investment guidelines and risk measurement. These traits are commonplace in the traditional investment world, and are expected by most large institutional investors.

Additionally, some institutions feel more comfortable with the brand and reputation that many of the major index providers provide. In our case, as a publisher we have immense business and reputational risk. We thought long and hard about entering this space and we realised as an organization that we could only put the Dow Jones name on an index if it denoted the same integrity that the public expects from our global index family and our financial publications.

In order to create a good product on which one can stake one's reputation, you need an underlying price you can count on. That's the case in any product whose value is derived off of another product. Look at the earliest derivatives markets. Without an accurate price for the underling commodity, there could not be a robust market in futures, forwards or options contracts.

Because of my derivatives background, I came to view hedge fund indices from a derivatives trader's viewpoint. I was committed to having Dow Jones provide the most accurate underling indices in this space given the many constraints and challenges present in an evolving market. We believe we've done just that.

We've created indices on six strategies that have inherent return streams that can be decomposed into specific market factors. By example, convertible abitrage can have its return stream decomposed into credit risk, volatility risk, interest rate risk and equity risk. Now each of those market factors can be measured and hedged or unhedged, as appropriate. Hence, products can be created efficiently because the optionality embedded in those products can be hedged. This is an exciting development in the hedge fund world that will allow for many unique products and structures in the not so distant future.

Obviously, creating hedge fund indices is not without its difficulties as well. Perhaps the biggest challenge in constructing a hedge fund index is data. The data set that is available is very different from what we take for granted in the traditional world. In fact, when we first looked at entering the hedge fund index space we tried to create securities-based hedge fund indices, with the thought being that if you could buy all the merger deals out there, you would, in fact, achieve the return stream from a merger arbitrage strategy. Unfortunately, even in what seems like a straightforward strategy, subjectivity still comes into play. You still must develop rules on when to execute, in what size, when to exit, etc.

We also looked at trying to model the market factors in a strategy, similar to what I described earlier in convertible arbitrage. In this instance, however, the loadings on those factors are typically regressed from previous data, and whether those loadings are correct in the future is anybody's guess.

So we had to rely on the next best approach, which was a rules-based methodology aimed at achieving the return an institutional investor could expect in a given strategy. This involved various quantitative and qualitative filters that define a subset of managers within a strategy.

Choosing a hedge fund index product

Still, just because index products often have strong name recognition for investors, daily prices and transparency, doesn't mean that investors can blindly invest. Investors should ask the same questions they would ask anyone to whom they give their money. What does the underlying manager, index provider, asset management platform or structurer have to lose in the transaction?

Each of those providers should be at risk in some way so that everybody's interests are aligned. Whether that risk is readily quantifiable, like a loss of dollars, or more abstract, like the loss of reputation or the impact on other related businesses, there needs to be that sharing of risk in some way.

Once that is established, the robustness of the process and how that fits the investor's needs should be examined. In our case, because the client base tends to be very large institutions, we err on the conservative side both in methodology and in the strategies we measure.  

The future of hedge fund indices

At the current rate one thing is clear: hedge fund indices and the products linked to them will continue to grow much the same way we saw indexation take hold in both the traditional equity and fixed income worlds. Five years from now I believe we will look back and see that investable hedge fund indices were a natural step in the maturation of the hedge fund industry. I sincerely believe that we will see that these indices provided for the financial engineering of new hedge fund products based on specific client needs.


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