Investable hedge fund indices have grown rapidly since 2003.
Investable hedge fund indices have grown rapidly since 2003. The major index compilers (MSCI, S&P, FT and Dow Jones) offer Investable Indices, as do providers who originate from the alternative asset arena, such as HFR and Tremont. Investable hedge fund indices are frequently presented as an alternative to actively managed funds of hedge funds. In this article the two approaches are examined, with a particular focus on the latter.
What funds of funds do
Funds of hedge funds are usually managed with the aim of achieving a specific rate of return with, in many cases, additional parameters based on volatility of returns and correlation to equities and bonds. Because many hedge funds are lowly correlated to each other and to markets, they lend themselves particularly well to portfolio construction. This feature means that leading fund of funds managers have developed expertise in structuring portfolios of hedge funds so that the portfolio volatility is much lower than that of the individual constituent funds.
As is evident from Figure 1, hedge fund strategies go through performance cycles and it should therefore be possible for a fund of funds manager to add value through dynamic strategy allocation. Also, Figure 2 shows that there is substantial potential for improving returns through manager selection, particularly in certain strategies. Funds of funds therefore tend to be managed through a combination of topdown strategy allocation and bottom-up manager selection.
A fund of funds can be viewed somewhat like a portfolio of equities with strategies being similar to market sectors and specific funds similar to individual equities. Although there is evidence of performance chasing in fund of funds management, both at the strategy level and the single fund level, a number of fund of funds groups have added value both through dynamic strategy allocation and through manager selection.
A fund of funds manager is only constrained in his opportunity to select from the vast pool of hedge fund talent by the fact that a number of funds are closed to new investment, and by the practical limits of his capability to identify, carry out due diligence on and monitor funds. Because the better funds of funds are respected by hedge fund managers, they can access funds which are not open to new investors, and moreover they entertain a dialogue with hedge fund managers which helps them to manage their portfolio to a higher standard.
Moreover, the larger fund of funds managers have developed expertise in risk measurement and risk management. Since many hedge funds do not provide full position level transparency, the risk assessment is based on an analysis of a fund’s historical sensitivity to various factors, combined with the risk reports provided monthly by the funds.
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1993 |
1994 |
1995 |
1996 |
1997 |
1998 |
1999 |
2000 |
2001 |
2002 |
2003 |
2004 |
YTD 2005 |
|
HFRI Macro |
HFRI Merger |
HFRI Sector |
HFRI Sector |
S&P 500 |
S&P 500 |
HFRI Sector |
HFRI Merger |
HFRI |
Lehman |
MSCI Indices |
HFRI |
Lehman |
|
HFRI Sector |
HFRI Sector |
S&P 500 |
HFRI Event-Driven |
HFRI Equity |
MSCI Indices |
HFRI Equity |
HFRI |
HFRI |
HFRI |
HFRI |
HFRI Event- Driven |
HFRI Merger |
|
HFRI |
HFRI Event- Driven |
HFRI Equity |
S&P 500 |
HFRI Event- Driven |
HFRI Equity |
HFRI Fund |
HFRI Relative |
HFRI Event- Driven |
HFRI Macro |
S&P 500 |
MSCI Indices |
HFRI |
|
HFRI Fund |
HFRI Fund |
HFRI Macro |
HFRI Equity |
HFRI Macro |
Lehman |
HFRI Fund of Funds Comp. |
Lehman |
Lehman |
HFRI Relative |
HFRI Sector |
HFRI Sector |
HFRI Event- Driven |
|
HFRI Event-Driven |
HFRI Relative |
HFRI Event-Driven 25.11% |
HFRI Fund |
HFRI Fund |
HFRI |
HFRI Event-Driven |
HFRI Equity |
HFRI Relative |
HFRI |
HFRI Event- Driven |
S&P 500 |
HFRI Fund |
|
HFRI Equity |
HFRI |
Lehman |
HFRI |
HFRI Merger |
HFRI Sector |
MSCI Indices |
HFRI Event- Driven |
HFRI Macro |
HFRI Fund of Funds Comp. |
HFRI Macro |
HFRI Fund |
HFRI Equity |
|
HFRI Relative |
MSCI Indices 3.34% |
HFRI Fund 21.50% |
HFRI Merger |
HFRI Fund of Funds Comp. |
HFRI Merger |
S&P 500 |
HFRI Fund |
HFRI Fund |
HFRI Merger |
HFRI Equity |
HFRI Equity |
HFRI Fund of Funds Comp. |
|
HFRI Fund of Funds Comp. |
HFRI Equity |
HFRI Convertible |
HFRI |
HFRI Relative |
HFRI Macro |
HFRI Macro |
HFRI Fund of Funds Comp. |
HFRI Fund of Funds Comp. |
HFRI Fund Comp. |
HFRI Fund Comp. |
HFRI Fund of Funds Comp. |
HFRI Macro |
|
MSCI Indices |
S&P 500 |
HFRI |
HFRI Relative |
HFRI |
HFRI Relative |
HFRI |
HFRI |
HFRI Merger |
HFRI Event-Driven |
HFRI Fund of Funds Comp. |
HFRI Relative |
HFRI Sector |
|
HFRI Merger |
HFRI Fund of Funds Comp. |
MSCI Indices |
HFRI Fund of Comp. |
MSCI Indices |
HFRI Fund Comp. |
HFRI Relative |
HFRI Macro |
HFRI Equity |
HFRI Equity |
HFRI |
Lehman |
HFRI Relative |
|
HFRI |
HFRI |
HFRI Merger |
MSCI Indices |
HFRI |
HFRI Event-Driven |
HFRI |
HFRI Sector |
HFRI Sector |
HFRI Sector |
HFRI Relative |
HFRI Macro |
S&P 500 |
|
Lehman |
Lehman |
HFRI Relative |
HFRI Macro |
Lehman |
HFRI |
HFRI Merger |
S&P 500 |
S&P 500 |
MSCI Indices |
HFRI Merger |
HFRI Merger |
MSCI Indices |
|
S&P 500 |
HFRI Macro |
HFRI Fund of Funds Comp. |
Lehman |
HFRI Sector |
HFRI Fund of Funds Comp. |
Lehman |
MSCI Indices |
MSCI Indices |
S&P 500 |
Lehman |
HFRI |
HFRI |
The fund of funds managers’ capability in risk management enables active management to avoid excessive concentration of a particular source of risk, e.g. emerging market equities, and to improve portfolio construction. The fact that the underlying hedge funds offer only moderate liquidity, typically one month to one year, means that risk monitoring is a particularly important task for a fund of funds manager.
In summary, funds of funds provide exposure to hedge fund strategies and, most importantly, to a selection of top investment talent within an actively managed portfolio which is monitored for risk.
Investable indices: a different proposition
Investable indices are a very different proposition. They are passively managed, sold on the basis of liquidity, transparency, low fees and a strategy weighting representative of the hedge fund ‘asset class’. In order to achieve these objectives, the index provider invests in managed accounts across a range of hedge fund strategies, with the selection and monitoring carried out by consultants.
The approach thus appears straightforward. In practice it is not. Firstly, many hedge fund managers, particularly the largest ones, will not take on managed accounts, and secondly, certain strategies, for instance fixed income arbitrage and distressed debt, are difficult to access in liquid, daily priced, segregated account format.
The fact that the hundred largest managers, out of a universe of approximately five thousand, represent over half total hedge fund assets and are lowly represented in hedge fund indices, means that it is inevitable that investable indices do not provide a capitalisation-weighted exposure to hedge fund talent.
The Box plot shows the distribution of returns divided by quartiles.
The Box contains the middle 50% of the observed returns (the upper edge of the box indicates the 75th percentile while the lower edge indicates the 25th percentile).
The ends of the vertical lines indicate the minimum and maximum data values.
The 2 lines represent, respectively, 25% of the values, which are included between the maximum value, and the 75th percentile and the remaining 25% of the values, which are included between the minimum value and the 25th percentile.
What indices do offer is an exposure to hedge fund strategies. In order to provide this and to reduce manager risk, they are broadly diversified. In effect, they are structured to deliver the Beta of various hedge fund strategies. Accordingly, they will almost inevitably be impacted by systemic risk and hedge fund events. Funds of funds in comparison tend to be more exposed to manager specific factors.
It therefore seems likely that well-managed funds of funds will substantially outperform investable indices in spite of the somewhat higher fees. Indeed, the figures since the beginning of 2004, when investable indices first became substantial, are revealing, with the fund of funds indices (HFRI, Altvest, EDHEC), which reflect the performance of several hundred actively managed funds of funds, having delivered approximately + 10% over the 19 months to 31st July 2005, whereas the investable indices (MSCI, S&P, FTSE) were up approximately + 4% over the same period.
Conclusion: will Investable indices continue to outperform?
This underperformance of the Investable indices is in no way surprising, and may well be a price thought worth paying by investors who attach great importance to liquidity, and who view hedge funds as strategies rather than as talent-based investing. The question that may be asked if the investable indices continue substantially to underperform the universe which they aim to represent is whether providers – MSCI, S&P, FTSE etc. – should have put their names to the offering. After all, in the equity world it is the likes of BGI, State Street and Vanguard who provide index tracking funds, not the index compilers themselves. 쳌¡
Author : Prior to co-founding Fauchier Partners in 1994, Christopher Fawcett worked for five years with Euris SA, a large French investment holding company with substantial investments in private equity and Hedge Funds. He gained experience of the securities industry with Morgan Grenfell, with Industrial Technology Securities, a venture capital company of which he was cofounder, and with the Duménil Group.
Christopher Fawcett has an MA in Law from Oxford University, an MBA with distinction from INSEAD and qualified as a Chartered Accountant. He is Chairman of the Council of the Alternative Investment Management Association (AIMA), and a Director of Mirabaud Gestion SA. He is a Director of Fauchier Partners Ltd and a Partner of Fauchier Partners LLP.
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