John Godden examines how the 'traditional' view of hedge funds as super high performance vehicles dominated by macro global traders is changing.
A wide range of strategies and sub-strategies involving virtually every asset class available across global markets now fall under the remit of the hedge fund. Ultimate diversity is the name of the game and everything from relatively straightforward equity-based strategies to systematic commodity trading and fixed income arbitrage, are used to provide a very neat solution to portfolio risk/return optimisation.
In addition, recent developments by leading players in the hedge fund of funds community have enabled institutions to access these returns without compromising on infrastructure - properly separating custody, pricing and risk control from management control.
The latest secret weapon in the battle for both wider acceptance and use of hedge funds by the investing community is transparency. But what is meant by references to clear visibility, or a lack of opaqueness? Visibility of what? A clear view for what purpose? How is it that this level of clarity can be achieved and why would we wish for such a clear view? What will we do with what we see? And will this vision in any way alter what is there?
A set of financial assets, all of which are used in other spectrums of the investment universe, form the basis of every hedge fund. Hedge fund managers, though, fearful the details of their complex investment strategies may fall into the wrong hands, have long cloaked these raw materials in secrecy. Obviously, there is a need to be very careful over the disclosure of any short positions held in a portfolio given the unlimited downside if an informed market player knows of your position and trades against you, but this must be balanced against a need for transparency.
The solution to this particular conundrum has appeared in the form of two sets of "intermediaries", acting as a friendly buffer between the sensitivities of the hedge fund manager and the information requirements of the investor. Both the fund of the hedge fund community and the array of risk measurement firms have the ability to take such data in its raw form and package the information in aggregated form to meet the risk measurements needs of the investor without compromising the manager.
So the solution to the provision of sufficient risk information to meet even the most exposure analytic-hungry institution (usually the investment banks or the pension companies) exists.
Hedge fund infrastructures have moved towards the accepted standards of custody as a distinctly separate function from investment control - particularly in the form of the managed account platforms that are becoming more prolific. The application of such a regime not only ensures that the positions held in a fund are reported accurately but that the valuations are made independently and without any conflict of interest with the investment manager.
Having created the environment for robust data delivery it is then possible to take the information and use it to provide an accurate picture of the risk being taken and the exposures being generated by a particular portfolio. To what use can this be put? The most obvious application is that of risk measurement - investors are able to have a complete picture of the aggregated risks across the fund of funds, which they can use to assess the various factors of importance to them. A further important application of this data is to better inform portfolio allocation decisions which can be made using much greater standards of exposure analysis providing a much more cohesive approach to exposure management across a portfolio.
Transparency, if it is interpreted to mean a clear view of aggregated risks using robust position-level reporting and pricing, is now a reality for many larger fund of hedge funds and the users of the risk measurement companies. The evidence is that the returns generated by such portfolios are not compromised through lack of access to high quality managers, indeed performance over time should be enhanced as a result of better, more precise portfolio allocation and the non-existence of risk-related blow-ups.
All portfolios at HFR are managed with the benefit of total, independently priced, daily information on the positions held by all component funds. This gives our portfolio managers the ability to tailor each portfolio to very exact risk and correlation frames and have a very clear view of portfolio exposures.
A further significant development enabled by the increased level of reporting and valuation accuracy brought by the managed account platform, is the investable hedge fund indices. These are easily accessible and are designed to bring the economic returns associated with hedge fund investments to a wider audience while allowing existing investors to access these returns in a more efficient, more focussed way.
Investable indices have rapidly established themselves on the hedge fund landscape and have attracted a significant portion of capital invested in hedge funds from a number of different sources. The HFRX Indices are a development of the original HFRI Benchmark Indices that have been the established Hedge Fund Indices since 1993.
Creating a global index for hedge funds can appear difficult on first sight due to the broad spread of different strategies that make up the universe from long/short large-cap equity through to fixed income arbitrage via credit and currency plays. Capturing the entirety of this community can be achieved in a number of different ways depending on the view of the interaction/separation between these strategy groups; however, there is a clear logic to the Indexation of an individual strategy such as merger arbitrage, as each of the strategy groupings exhibits strong clustering.
As the label of hedge funds is applied to a widely diversified collection of strategies, an important attribute of which is the low-levels of correlation between the various elements, any attempt to provide an accurate proxy must be constructed using a bottom-up strategy approach, defining and populating each strategy group separately. Any global representation is in a component form in order to provide the potential for different elemental construction such as an asset-weighted allocation across the strategies.
In order to deliver a representative of the full community, HFRX offers two Global Indices. The first is an asset-weighted allocation to the eight strategies, the other an equally weighted basket. Users are then left to decide which provides appropriate representation for their particular requirements. Alternatively, users can select their own weighting to achieve a customised benchmark.
The appeal of hedge fund indices lays in ease of use and easy accessibility to the economic returns required without any compromise on infrastructure security, valuation or risk control.
Global indices are 'one-size-fits-all' and may or may not match the requirements of an investor. FoHFs by comparison, allow for a more tailored approach. Such 'index-plus' funds are already in evidence.
Current trends suggest that institutional investors in particular are using investable indices as the first step along the road towards serious participation in hedge funds. A holding in an investable index provides a strong source of information, enabling institutions to move up the learning curve rapidly as they are able to see the dynamics of their investment unfold. This experience can then be used to invest in a fund of funds and may then possibly lead onto direct investment in individual strategies or even funds themselves.
By John Godden, HFR Asset Management.