Investable Indices – Some Technical Considerations

In this article we consider some technical questions on the construction of investable indices before briefly reviewing the main indices commercially available.

General  considerations  in hedge  fund  index  construction

An  index  is  a  means  of  summarising information  about  a  broader  population.  In the  case  of  public  exchange  traded  financial securities  such  as  equities,  this  population can  be  identified  exactly  and  the  various competing  indices  can  be  compared  in respect  of  their  ability  to  capture  the information  in  the  population  in  an  efficient manner.  Even  so  there  may  be  no  single ideal  index  because  sometimes  a capitalisation-weighed  index  will  be  preferred to  an  equal-weighted  index  but  sometimes not.  But  everything  is  transparent  and  users can  make  clear  choices.

Matters  are  less  much  less  clear  with hedge  funds  because  there  is  no  way  of identifying  the  total  universe  or  segments within  it.  This  is  because  hedge  funds  are broadly  unregulated  and  are  not  obliged  to provide  details  to  outsiders.  So  the  starting point  for  any  index  is  the  database  of  funds the  index  hopes  to  represent. Several  providers  have  established databases  of  hedge  funds  (usually  including commodity  trading  advisers  but  not  always) in  the  last  decade  or  so.  One  might  expect that  they  would  track  substantially  the  same set  of  funds,  so  that  each  database  could  be seen  as  a  ‘sample’  from  the  underlying  but unobservable  population.  In  this  case  the growth  of  samples  would  lead  to  a  growing confidence  about  the  scale  and characteristics  of  the  underlying  population. Unfortunately  the  various  databases  have surprisingly  limited  overlap.  Lhabitant  (2004 p.114)  shows  that  the  TASS,  HFR  and CISDM/Hedge  databases  only  overlap  for some  10%  of  the  total  funds  in  the  combined group.  Each  fund  accounts  for  little  more than  half  of  the  combined  total  of  funds. Users  therefore  may  lack  confidence  in  the ability  of  any  one  database  –  and  therefore index  –  to  capture  the  whole  hedge  fund universe  at  this  point.

The  lack  of  transparency  of  hedge  funds leads  to  other  problems  that  are  partly familiar  from  the  mutual  fund  world.  These are  potential  biases  that  can  creep  into indices  and  provide  an  inaccurate  measure of  what  is  going  on  in  the  population.  The main  biases  that  have  been  identified  in hedge  fund  indices  are:

• Survivorship bias. Many hedge funds cease operations and drop out of the universe and therefore the index; commentators normally assume that these funds have failed or suffered large redemptions although there is evidence that many funds close because their managers want to move on, in which case the funds may have been successful. But, to the extent that most funds that drop out are poorer than average performers, the index will overstate the returns an investor in a ‘typical’ hedge fund would expect. This problem is equally applicable to conventional equity indices (and to the population of stock market indices as a whole) but it matters more in the hedge fund world because of the relatively short time periods over which the effect can occur. Most index providers therefore now continue to include defunct funds in the index as of their last reported performance.

• Self-selection  bias.  Owing  to  the  private nature  of  the  industry,  hedge  funds  may choose  whether  to  report  to  a  database.  If non-reporting  funds  are  systematically different  from  the  reporting  funds  then  the database  and  any  indices  based  on  it  will be  biased.  But  the  nature  of  the  bias  is ambiguous.  Poorly  performing  funds  may choose  not  to  report,  which  would  mean the  index  was  biased  upwards. 1   But  well established  and  well  performing  but closed  funds  may  also  choose  not  to  take part,  in  which  case  the  bias  could  be negative.  Of  course  if  funds  are  closed they  are  not  relevant  in  any  case  to  an investable  index,  which  therefore  must necessarily  diverge  from  the  established universe  of  funds,  even  if  that  could  be accurately  established.

Criteria  for  a  good  index

Assuming  that  the  database  from  which  an index  is  constructed  is  good  enough  to represent  the  underlying  population  of  hedge funds,  a  useful index  ought  to  be:

• Transparent:  the  index  provider  should readily  provide  the  constituents,  criteria  for inclusion  and  process  for  making  changes
• Representative:  the  index  should  include funds  from  the  full  range  of  fund  types, including  various  strategies,  sizes  and ages  of  fund;  most  importantly  the  fund should  include  both  the  best  established and  very  successful  funds  as  well  as  the less  successful  ones
• Timely:  the  index  needs  to  be  published regularly,  at  least  monthly
• Stable:  there  should  be  no  revisions  to the  index

The  question  of  weighting  is  somewhat controversial.  Whereas  the  original  Dow Jones  Industrial  30  index  of  leading  US stocks  was  and  remains  equally  weighted, the  main  indices  of  the  US  stock  market  are now  capitalisation  weighted  eg  the  S&P  500. This  is  regarded  as  obviously  correct  by most  users.