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Alternative Investments - April 06, 2005

An interview with François-Serge Lhabitant, Associate Professor with Edhec Business School

François-Serge Lhabitant, PhD, is Associate Professor of Finance at EDHEC Business School, Professor of Finance at the University of Lausanne, and a senior advisor to Kedge Capital Partners. Professor Lhabitant has substantial experience in risk management and alternative investments, as both a practitioner and an academic.

François-Serge Lhabitant

A few years ago most market participants considered hedge fund indexing to be non-sensical, given the “absolute return” nature of hedge fund strategies. How can you explain the success that peer indices have experienced in the meantime?

François-Serge Lhabitant: Access to elite managers is often limited to very large institutions and very wealthy individuals. So, many private and institutional investors see hedge fund indices as a passive way of getting broad exposure to alternative investments without having to do the due diligence, portfolio construction and monitoring exercises required when investing in single strategy hedge funds. Indices also form a benchmark against which the performance of funds of funds can be compared.

The alternative arena is still in its infancy. In particular, it suffers from an acute lack of transparency. Information disclosed to the public is therefore scarce and its quality is challenged. What are the consequences for hedge fund indices?

François-Serge Lhabitant: Many hedge fund indices are equally weighted rather than asset weighted, which corresponds to a strategy that would sell the winners to buy the losers – the opposite of what investors tend to do. In addition, hedge fund indices are subject to numerous construction biases (self-selection, survivorship, backfilling of the track record, etc.).

Would you say that the hedge fund indices available on the market are good indices? More specifically, can investors rely on hedge fund indices and use them in their performance measurement process?

François-Serge Lhabitant: As relative performance takes a greater and greater role in alternative markets, choosing a good index will become a more and more important decision. Unfortunately, so far, many hedge fund indices are based on small samples of funds, which are not representative of the industry and provide very heterogeneous performance. This is likely to bias their conclusions in any performance measurement process.

The considerable heterogeneity of hedge fund indices’ returns is somewhat confusing. In certain month the performance differential between two indices covering the same investment style can exceed 20%! What should an investor who is looking for a true and fair picture of hedge fund strategies do?

François-Serge Lhabitant: It all depends on what investors want. If one requires a specific tailor made hedge fund index, one can analyze the existing ones to see if they match or even build a new one. But this new hedge fund index will basically be a fund of funds in disguise, and there is no reason to expect it to be representative of the overall universe! Otherwise, one should consider an “index of indices” instead of choosing one particular index since there is no consensus on what is the best index.

You have carried out representativity tests on the hedge fund indices. How representative are the Edhec indices of indices relative to the indices available on the market? What tests did you carry out and what did the results indicate, in terms of bias for example?

François-Serge Lhabitant: The EDHEC indices apply principal component analysis on competing hedge fund indices. They are based on the first principal component, which captures a large proportion of the common information across indices. Statistically, there is no other linear combination of competing indexes that implies a lower information loss and a lower bias.

Our empirical tests confirmed this. Starting with a large sample of 7422 hedge funds, we have constructed equally weighted portfolios of funds for each of the EDHEC strategies. We have then calculated the correlation coefficients of these portfolios with the indices published by the different providers, and compared it with the correlation with the corresponding EDHEC index. The EDHEC indices are systematically better correlated with the representative portfolios than the average of the indices they are made up of.

Then, for each investment strategy, we have ranked the different providers according to their correlation coefficients. Not surprisingly, thanks to their construction methodology, the Edhec indices dominate the other indices across all strategies.

François-Serge Lhabitant will be giving an exclusive seminar on the state-of-the-art in hedge fund investment on June 23rd in London. For more information, please contact AIeducation@edhec.edu.