Comment: Will investable indices survive?

Primores Absolute Return Investing asks whether it's worth paying for the 'advantages' investable indices provide…

The following extract is taken from an announcement by PlusFunds Group in 2002 backing the launch of the S&P Hedge Fund Index:

'However, fund of fund managers vary widely in their ability to deliver these benefits [access, reporting, diversification…] on a sustainable basis and the extra layer of management entails additional management and performance fees, which raise performance requirements even higher. Indexing offers investors the potential to efficiently achieve diversification across the major hedge fund strategies, plus a clearly defined market exposure - without the uncertainties of placing faith in a fund of funds manager.')

About four years later:

• The S&P decided to no longer publish its managed account based Hedge Fund Index,
• PlusFund filed for Chapter 11 and is told to go out of business by the end of July,
• PlusFund sued S&P over its decision to pull the plug on the index.

There have been studies like: 'Hedge Fund Indices: A new way to invest in absolute return strategies' from Lars Jaeger, Partners Group, discussing the different aspects of such indices. We would like to point out a few of the main attributes of such indices:

• Investable Indices serve as a benchmark for a lot of investors.
• They offer higher transparency in a few aspects (e.g. like portfolio construction, selection guidelines).
• Investable Indices have limited access to the Hedge Fund Universe.

In our view, there is one main question an investor has to ask himself: how much is one willing to pay to get something additional? In the case of Investable Indices the question is, how much are you willing to pay (through lower performance because of limited access) to get the higher transparency (and probably better liquidity).

What did an investor who allocated his money to an Investable index pay in the past? To answer this question we need another benchmark. In our opinion there exist two options:

1. Either you compare to Fund of Hedge Fund Indices. In this case you have to take into account that there are some biases in these indices (survivorship/self selection/reporting biases). For sure, these biases are smaller than the ones for Hedge Funds indices, which are estimated to be around 3%. As a rough estimate subtract 1% from these returns.
2. Or you compare to a very broadly diversified Fund of Hedge Funds covering all strategies and geographies. Forgive us for comparing with our own fund, but as PrimFund Diversified aims to be a one-stop solution for hedge fund investing with more than 250 underlying Hedge Fund investment, it seems well suited for such comparison.

The quantitative comparison can be found in following table:

According to this overview, one pays between 2.1%and 4.2% to get the advantages of Investable Indices.

As the return characteristics of Fund of Hedge Funds are typically stable, the costs of around 3% are substantial. At the end of the day an investor has to decide himself whether he is willing to pay this premium for the additional advantages of Investable Indices.