It's a challenge measuring something that changes as fast as the hedge fund industry. Trying to shrug off its roguish reputation while still promising the brainpower to deliver alpha in any market cycle, hedge funds are rapidly entering the mainstream.

The creation of indexes in any kind of market is a benchmark in itself, signaling maturation, demand for standardisation and the potential of the broader investing market lining up at the gates to get inside. But despite some concerns, it is anything but a sign that the industry has reached its high water mark. Indeed, as debates over what constitutes a proper index in this field rage on, it's clear we've only scratched the surface of where hedge funds will take us in the years ahead, and the impact they'll have on the markets at large.

The Appeal of Hedge Fund Indexes

Hedge fund indexes strive to capture many of the ideals of their equity and bond cousins. To begin with, indexes bring a sense of order to balance sheets tracking dozens or hundreds of investment vehicles. This is as true for a modern pension fund researching convertible arbitrage performance as it was in 1893 when Charles Dow was scratching his head over the railroad sector.

Second, as shorthand representatives for market segments, indexes enable investors to quickly enter and exit an investment without researching every last component.
The past 10 years have shown a willingness by investors to use index funds to try new strategies and approaches in their portfolios. Opacity-driven fears in emerging markets have been trumped by indexes that capture the market in total, and provide access to the attributes affecting the region as a whole.

This familiarity will be an important driver of hedge fund indexes, as investors seek the returns alternative investments offer, even if each underlying strategy is not fully understood.

Myth of the Composite Hedge Fund Index

Before delving into what makes a proper hedge fund index, we must expose the fallacy that any one index can measure the whole industry. Sure, a single index can tell you how the entire U.S. equities market is doing. The same can be said for commodities, dividend style investing and other markets and sectors. At the very least, these kinds of indexes can be used as benchmarks to reveal whether a certain investment manager is handling your money better or worse than a passive alternative.

But how could any index hope to capture or even begin to indicate the performance of a strategy like global macro? There is no shortage of mathematics PhD's who would love to create an index that tells you whether a manager simultaneously placing bets on the Yen, the price of pork bellies, real estate and private equity, is doing as well as he or she could against their peers.

Because global macro and other strategies defy such categorisation, the goal of measuring the hedge fund industry as a whole with a single index is not achievable. It is for this reason that Dow Jones Indexes employs a philosophy of measuring what can be measured. Past that point, purity,investability, transparency and stability guide the decision making process.

Building 'Style-Pure' Indexes Hedge fund indexes must be based on quantitative methods paired with constant qualitative due diligence. Each index should represent a portfolio of managed accounts to ensure diversification, each of which reflects the returns and risks of a specific strategy. This is accomplished by using a portfolio of approximately five to eight style-pure managers that capture the risk and return characteristics of a style-pure portfolio within a selected strategy. Too few managers in each strategy could result in excessive volatility and too many managers create outsized costs in administration and monitoring. With Dow Jones Indexes' family of hedge fund strategy benchmarks, five to eight components was deemed optimal. Among our six strategies of equity market neutral, convertible arbitrage, distressed securities, merger arbitrage, event driven and equity long short (U.S.), there are currently 33 managers. Each benchmark is substantially equally weighted among its component managers to minimise the chances of one manager's performance skewing the performance of a benchmark.

Selecting managers is one of the most important steps an index creator takes in bringing a product to market. Adherence to quantitative and qualitative principals ensures the best industry practice. At Dow Jones Hedge Fund Indexes, for example, manager selection starts with publicly available databases and other information sources. Managers must have a track record of at least two years and a minimum of $ 50 million under management. Cluster and other quantitative analyses partition data into sets of similar members, eliminating over- or under-performing outliers. Due diligence is performed, including intense qualitative reviews and background checks.

Managers must be able to credibly show and have established the capability of executing the 'core' business of managing a portfolio and generating performance. A manager must have the investment infrastructure necessary to support its business. Style purity is essential. On-site visits are also a regular part of the review process. Finally, managers are reviewed by an oversight committee. The committee consists of leaders in the hedge fund community who actively review the benchmarks, helping to ensure objectivity and 'best of breed' methodologies. Once selected, manager's activities are monitored ongoing. For instance, their use of leverage must be consistent with the typical leverage used in each strategy. At each step the achievement of purity - not performance - is the guiding principle.

Achieving Transparency

Transparency, the final ingredient, is achieved by implementing the risk controls often sought by institutional investors and the ability to report daily returns. The names of all hedge fund managers are also made public. Transparency is ultimately delivered at the end-user level by the publishing of daily valuations. The result is that each of the six Dow Jones Hedge Fund Strategy Benchmarks has known style attributes and known exposures to market factors, as well as an inherent return stream. Though managers will differ somewhat in trading style and asset management approach, the managers' common strategy characteristics drive the returns. For example, every convertible arbitrage manager's returns is based on credit risk, implied volatility risk and, to a lesser degree, term structure of interest rates and beta or systematic stock market risk.

Challenges Ahead

Like the assets they track, hedge fund indexes face challenges in gaining widespread acceptance. Two areas of potential risk in particular require constant vigilance: style drift and transparency in pricing. There are a number of measures which tend to the former, including computerised tracking, regular on-site, in- person inspections and regular audits to ensure managers stay on track. Diversification plays a stop-gap measure here too, as a manager drifting off course will be buffered by his or her fellow index component managers.

Transparency is a more complicated challenge. Regular reporting of figures is standard, but that tactic assumes the figures such as OTC vehicles have been
correctly valued by the prime broker. Often the valuation of hedge fund holdings is not accurately known until the holdings are sold. Institutions or high net worth
investors take these problems in stride, because they are accepted as normal within the industry.

On the Horizon

Ultimately, the flow of assets into the hedge fund industry and the use of hedge funds by more institutional investors will drive the creation of more sophisticated structured products that serve specific objectives - porting of alpha, for example. The creation of these objective-based products will in turn drive the creation of new benchmarks that are more product- focused, liquidity, transparency and frequency of pricing, excepted. In the meantime, as rigid and reliable as any hedge fund index must be to achieve mainstream acceptance, its management and advancement must be anything but passive. Strict monitoring of managers, the use of separate accounts, and other tactics outlined above mark only the beginning of these endeavours. And as much as these instruments will change and grow in the years ahead, we can take comfort that the principles of purity, transparency, innovation and will guide their course. 쳌¡

Click here to download the full winter edition of HedgeQuest - "The Global Reach of Investable Hedge Fund Indices"

Ridgely Walters is senior director of Client Development and Sales for Dow Jones Indexes and has responsibility for business development in the Americas.

This article was provided by Ridgely Walters to form part of the Hedge Quest Winter edition. Mr Walters joined Dow Jones & Company in 1985 and participated in the development of the Dow Jones Global Indexes since their inception in the early 90s. Mr. Walters managed the Corporate Information Services statistics group from 1995 to 1999 where he was responsible for the development of new index series and managing the market data and index production operation. He was a member of the Dow Jones STOXX index design committee when it began in 1997. In 1999 Mr. Walters became the director of Index Operations for Dow Jones Indexes and in 2001 he became the director of Index Services for Dow Jones Indexes with responsibility for project management of index product development and support for Dow Jones Indexes. In 2003 Mr. Walters was appointed to his current position and also became the president of Dow Jones Hedge Fund Indexes, Inc.

Mr. Walters received a Bachelors of Science degree in Finance from Lehigh University, Pennsylvania.

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