By the end of the 20th century, hedge fund strategies were no longer viewed as 'isolated cases'. but became recognised as investment styles in their own right.
An important progress associated with hedge funds is the possibility for the fund manager to take leveraged positions and short positions in securities. The additional freedom acquired by the fund manager brings formidable diversification in risk profile and performance potential.
The following risk-return graph simply compares different portfolio investing in Equityies (represented by the S&P 500 with Dividend Index), in Fixed Income (represented by the Lehman Brothers Government/Credit Aggregate Index) and in Hedge Fund (represented by the HFRX Global Index).
Click here  to view the graph displaying the annualised return and the annualised standard deviation (based on monthly data) of portfolio investing S&P 500 with Dividend Index, the Lehman Brothers Government/Credit Aggregate Index and the HFRX Global Index. The back testing is based on the monthly data from January 1998 to December 2004. Source: Bloomberg.
The graph demonstrates that leverage, including taking short positions,can be used to improve the risk-return profile of investments in hedge funds as well as pure equity or fixed income investments.
The growth in the size of hedge fund mandates has increased the difficulty of understanding the investment approach of hedge fund managers. Various factors need to be considered, including: The description of the approach; the specification of the market considered; the types of securities used; the amount of gross and net leveraged allowed; the type of risk taken and hedged out... the variety of factors implies that the performance of a hedge fund is much more driven by the capabilities of the fund management team than in the realm of long-only investment universe.
To help investors understand the strategy of each hedge fund manager and choose from more than 6000 existing single hedge funds, HFR Asset Management divides the hedge fund universe into eight representative investment strategies which are globally recognised and used within the industry.
In April 2003, HFR launched HFRX, a familyt of investable indices which allow investors exposure to the specifics of the eight investment strategies without having to select and invest in each separate hedge fund. Similar to the index approach used for mutual funds (i.e. index trackers), the index approach in the hedge fund world is very successful.
To alleviate the risk associated with investing in a single hedge fund, investors have typically invested in funds of hedge funds. The fund of hedge fund approach allows diversification of the risk associated to any single hedge fund and a more global approach through a dynamic strategy allocation as a function of the market outlook.
The fund of hedge fund approach is often used to constraint the risk profile of the investment by, for example, including a minimum number of hedge funds- and reducing the standard deviation by choosing hedge funds which are weakly correlated and/or through imposing constraints on strategy allocation.
An alternative to the traditional fund of hedge funds approach, which is becoming increasingly popular,, is to create a fund of hedge fund that invests directly in investible indices. This approach assumes that on average most of the investment returns are due to effective strategy selection rather than manager (or individual hedge fund) selection.
Additionally, if the fund of hedge fund invests solely on a platform of managed accounts, like the one developed by HFR, the manager has access to information concerning the sum of the portfolio of positions (at the securities level) held in each hedge fund that the fund of hedge fund is invested in.
For example, the report could include the aggregate exposure to a specific market across all the hedge funds within the basket, or to perform relevant scenario analyses on the fund of hedge funds.
It is very difficult, for a fund of hedge funds manager to take a position from which the fund of hedge fund would profit if a specific strategy demonstrates negative performance. Similarly, it is not easy for a fund of hedge fund to acquire a leveraged exposure to a hedge fund or a strategy index and to capitalise on the strong belief that it would perform.
As a consequence HFR has decided to launch Short Indices, These indices will provide investors with the negative performance of the underlying index. For example, an investment in the HFRX Short Convertible Arbitrage Index would have a return of 10% if the HFRX Convertible Arbitrage Index was showing a return of -10%.
In parallel, HFR will be launching leverage indices, which will provide twice the return of the underlying index (gross of fees). For example, the HFRX 2X Equity Hedge Index would return twice the return of the HFRX Equity Hedge Index minus costs.
With the short strategy indices and the leverage strategy indices, the long-only fund of hedge funds will be a sub-category within hedge funds of hedge funds.