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.

But  in  the  hedge  fund  world  the  scale divergence  between  the  largest  and  smallest funds  is  enormous.  Most  hedge  funds indices  are  therefore  equally  weighted,  the
main  exception  being  MSCI.  An  index weighted  by  assets  under  management (AUM)  would  arguably  be  more representative  of  the  industry,  but  would practically  exclude  the  influence  of  many new  and  small  funds.  These  funds  are  more likely  to  be  open  to  investors  so  and investable  index  is,  in  effect,  forced  to  be equally  weighted.

Another  argument  for  equal  weighting  is diversification.  To  the  extent  that  the  index intends  to  capture  the  experience  of  a 'representative'  hedge  fund  investor,  that investor  would  probably  wish  to  have  some degree  of  diversification  over  funds  and strategies.  An  equally  weighted  index  should achieve  this.  An  AUM-weighted  approach would  potentially  concentrate  the  index  on more  successful  strategies  and  funds,  as well  as  being  influenced  by  the  latest fashionable  money  flows.  On  the  other  hand, if  the  index  is  intended  to  capture  the  reality of  what  is  happening  in  the  global  hedge fund  universe,  it  should  reflect  these  flows.

There  is  no  ideal  answer  to  this  question  but in  practice  equal  weighting  is  more commonly  used.2 The  final  criterion  for  an  index  is investibility.  The  Standard  &  Poors  Hedge Fund  Indices  were  created  from  the beginning  as  investable.  Most  other  index providers  initially  provided  non-investable indices  and  then  added  investable  indices later  on.  The  main  reason  for  offering  both  is the  conflict  between  investibility  and  some  of the  criteria  above,  chiefly  that  the  index  be representative.  An  index  can  be  relatively broadly  based  and  achieve  high representativeness,  but  be  non-investable.  Or it  can  be  investable  but  much  more  narrowly based  and  therefore  potentially  less representative.  Index  providers  rely  heavily on  statistical  tests  to  maximise  the  efficiency of  this  representative/investable  trade  off (see  below).

Construction  of  an  investable index

Investable  index  providers,  starting  from  a database  of  hedge  fund  data,  typically  go through  the  following  steps  in  constructing their  index:

Figure 1: VAN Hedge Fund Indices:

  Number of Constituents

 Van Database

c.6,700 funds

   

 Van Global HF Index

c.2,000 funds

   

 VI2 Investable Index

60 Funds

 Source : VAN Composite Investable Index

 Construction Methodology July 2005

  • Quantitative  screening
  • Qualitative  screening  (due  diligence)  - often  using  a  third  party
  • Confirmation  of  data  and  valuations  - often  using  a  third  party
  • Filtering  for  various  criteria:  minimum investment  capacity,  performance  history, scale  etc.

1. Quantitative screening

The  key  challenge  for  an  index  provider  is  to find  a  number  of  funds  that  are  open  to  new investment  and  satisfy  the  other  criteria  (see below)  but  are  representative  of  the  strategy that  the  index  seeks  to  capture.  In  practice this  means  using  a  very  small  number  of funds  relative  to  the  whole  database  of hedge  funds,  or  even  relative  to  a  broad  non- investable  index  (see  figure  1).

The  first  step  is  classifying  the  funds  by strategy.  It  is  not  enough  to  take  the  fund managers'  self  reported  description  as  given. Instead  index  providers  use  correlation analysis  and/or  cluster  analysis  to  identify funds  that  clearly  behave  in  a  group  with other  funds  of  a  given  strategy.  Funds  that appear  to  be  too  far  from  the  group  are excluded.  This  of  course  excludes  any  fund that  achieves  good  performance  but  in  an 'undisciplined'  way.  It  also  assumes  that  all strategies  do  fall  into  statistically  neat groups.  For  conventional  and  well established  strategies  such  as  convertible arbitrage  or  merger  arbitrage  this  is  a reasonable  assumption  and  funds  employing these  strategies  do  show  a  low  level  of strategies  may  not  easily  be  classified  and so  may  be  excluded.

Assuming  that  a  sub-universe  of  strategy-defined  funds  has  been  identified,  the  next investable  and  fulfil  the  other  index  criteria. The  question  is  how  many  funds  are  needed for  the  index  accurately  to  capture  the performance  of  the  overall  strategy?  This  is simulations (Monte Carlo analysis).  These simulations  show  that  some  strategies  can be  pretty  well  captured  by  only  10-15  funds but  for  others  it  may  need  to  be  over  20.  For an  aggregate  index  over  all  strategies (capturing  the  whole  hedge  fund  universe)  a total  of  50-60  funds  is  normally  sufficient  to give  very  good  correlation.

Clearly the more broad the index, the easier it is to find enough funds that meet the investable criteria to make it statistically robust. It is relatively straightforward to find enough funds to construct broad style indices (eg market neutral or absolute return). Finding enough for single strategy indices is much more difficult so although there are various sub-indices for detailed strategies they are not always intended for stand alone use.

2. Qualitative screening (due diligence)

Unlike  say  the  S&P  500  index,  the components  of  a  hedge  fund  index  require some  form  of  qualitative  assessment.  All index  providers  include  a  due  diligence  stage in  selection  which  would  include  auditing  the fund's  accounts,  checking  the  educational and  other  credentials  of  the  employees, verifying  the  style  consistency  and  perhaps taking  up  investor  references.  This  process is  often  conducted  by  a  third  party,  since expertise  in  index  provision  is  quite  separate from  expertise  in  fund  due  diligence 3.

In  this  respect  the  index  provider  is straying  into  the  territory  of  fund  of  hedge funds  (FoF)  managers.  Many  FoF  managers would  argue  that  much  of  their  expertise  lies in  the  -  inevitably  subjective  -  assessment  of individual  fund  manager  quality,  integrity  and business  competence. 

 

Investable Hedge Index Comparison

nc

nc

Performance Measures

Index Construction

Constituent ManagerRequirements

nc

Historical
Proforma

CAR
(Jan03 to Jul05)

Tracking Error
(Jan03 to Jul05)

Number of
Funds in
Investable Index

Investable Index Weighting-
Strategy/Managers

Rebalancing
Frequency

Liquidity

Pricing

Separately
Managed
Accounts

AUM / Track Record
Required

Van

VI2 - Van Composite
Investable index

nc

nc

nc

nc

11.80%

0.41%

45

Proportional to Strategy Weights in
Van Global HF
Index / EW

Semi-Annually

Monthly + 30 Days Notice

Monthly

No

520M / 1Year

CSFB/ Tremont

INVX

HF Asset Class

CSFB Hedge Fund Index

August, 2003

Yes
Jan'00 - Jul'03

7.02%

-3.91%

60

AW/AW

Semi-Annually

Weekly / Monthly / Quarterly

Weekly estimates

No

550M / 1 Year

nc

nc

nc

nc

nc

nc

nc

nc

nc

HFRX Global -
AW/AW.
HFRX EW - EW/EW

ncnncc

Weekly/Monthly

nc

nc

nc

MSCI

MSCI Hedge Invest

HF Asset Class

MSCI Hedge Fund Index

July, 2003

Yes
Jan'00 - Jun'03

4.52%

-4.75%

120

Adj Mean AW/EW

Quarterly

Weekly

Daily estimates

Yes

Lyxor Platform Rules

nc

nc

nc

nc

nc

nc

nc

nc

nc

nc

nc

At least Quarterly

nc

nc

ncnc

FTSE

FTSE Hedge

HF Asset Class

N/A

July, 2004

Yes,
Jan'98 - Jun'04

6.36%

N/A

40

CW/CW

Annually

Weekly

Daily GAV/NAV

Yes

SSOM /  2 Years

Dow Jones

nc

nc

nc

ncnc

Figure 2 Investable Index Comparison

Source : Index provider websites and methodology documents; tracking error calculations by Hedgequest

Screening  out  the clearly  inept  managers  is  a  key  way  to ensure  superior  returns.  FoF  managers  also claim  to  add  other  skills  -  identifying interesting  new  investment  strategies,  asset allocation  among  different  styles  and negotiating  access  to  otherwise  closed funds.  Whether  FoFs  are  in  direct competition  with  investable  indices  is  partly  a matter  of  how  well  one  judges  FoFs  to achieve  these  other  goals.

3. Transparency: confirmation of pricing and valuation.

Any  fund  willing  to  be  in  the  investable  index must  reach  a  high  level  of  transparency  and reliability  in  its  data  provision.  Normally  index provides  want  daily  data  and  they  may  use additional  third  party  specialists  to  verify  the pricing  of  investments  in  illiquid  or  unusual securities.  The  pricing  of  illiquid  investments can  involve  a  significant  degree  of  judgement and  is  known  to  provide  hedge  funds  with some  scope  for  smoothing  their  returns,  so this  step  adds  value  to  the  index  user  who might  not  otherwise  be  in  a  position  to  verify pricing.

4. Filtering for various criteria.

The  index  providers  have  various  criteria  for fund  inclusion,  including  the  history  and  size of  the  fund.  These  are  shown  in  figure  2  for some  of  the  main  investable  index  providers. Figure  2  shows  that  the  index  methods are  not  very  different  from  one  another,although  the  actual  performance  varies  quite a  lot.  It  would  be  wrong  to  conclude  too much  from  these  figures  without  analysing the  riskiness  of  the  indices.

Additional  descriptive  information  on  the indices  is  provided  in  figure  3. 

Figure 3 Additional Information on Some Major Investable Index Providers

Broad HF Indices

I d
P         

k l   N mb f F d i
m      D t b

fo

95/J

99/J

HFR

94/J

MSCI

02/J

S&P

02/J

FTSE

98/J

D w J

03/J

 

 

 

 

 

 

 

Source: Index provider websites and methodology documents. 

Click here for the full Hedgequest report on Investable Hedge Fund Indices

References:

Barry,  R.  (2003),  'Hedge  funds:  a walk  through  the  graveyard', Working  Paper,  Ross  Barry Macquarie  Applied  Finance Centre.

Fung,  W.  and  D.A.  Hsieh  (2000),
'The  risk  in  hedge  fund strategies:  theory  and  evidence from  trend  followers',  Review  of Financial  Studies,  14  (2),  313-341

Lhabitant,  F.S.  (2004)  Hedge Funds:  Quantitative  Insights, John  Wiley  &  Sons,  Chichester

Footnotes:

1.    The  fact  that  new  funds  can choose  when  to  join  a database  also  introduces  a type  of  bias,  especially  if  it comes  with  data  on  the fund's  history  -  the  so-called instant  history  or  'backfill' bias.  Index  providers typically  do  not  add  the history  of  a  new  fund  to their  index  but  the  database from  which  the  index  draws may  show  annualised  return bias  of  around  1%  according to  some  academic  work (Fung  and  Hsieh,  2000  and Barry,  2003).

2.   MSCI  uses  an  asset weighting  approach  based on  the  median  assets invested  in  a  particular strategy,  rather  than  the aggregate,  combined  with  a six month moving average  to increase  stability.

3.   Standard  &  Poor's  for example  uses  DPM
(Derivatives  Portfolio Management),  a  firm established  in  1993. 

taylor.jpgAuthor - Simon Taylor is a Senior Research Associate of the Judge Business School, Cambridge University. Prior to this he spend fourteen years in the investment banking world, as an equities analyst at BZW and Citigroup and then as Deputy Head of European Equities Research at JPMorgan. He was previously a Fellow in economics at St. Catharine's College, Cambridge and an Overseas Development Institute Fellow in the Central Bank of Lesotho

Please click here to download the full hedgequest report The Global Reach of Investable Hedge Fund Indices

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