Indices, or more generally, benchmarks, play a central role in FoHF reporting. As a result, the first part of this article will show the extent to which the choice of an index provider may influence the answer to the aforementioned questions and as a result impact the strategic investment decisions of investors. The second part will present an index construction methodology that responds to investors' need for accurate and reliable information.

FoHF Reporting: Investors should not understate the importance of benchmark selection

The first objective of FoHF reports is to inform investors about the performance of the fund. To do so, the solution adopted by 62% of European multi-managers is to compare their performance to the return of an index (see Edhec (2003)). However, as evidenced in Amenc and Martellini (2003), the different indices available on the market may present dramatically different returns. The choice of the index providers will thus significantly influence results.

The second objective of FoHF reports is to improve investors’ understanding of the fund. Is the manager doing well because he is very good at implementing the strategy he claims to follow or because he drifted away from his original strategy to take advantage of new opportunities? Conversely, is the manager performing badly because his strategy is suffering from bad momentum or because he is trying to implement strategies that he is not good at?

Alternative investment strategies are generally included in investors’ portfolios for their diversification benefits. It is thus crucial for investors to monitor the fund’s investment style and to check its consistency over time. To do so 47% of European multi-managers perform style analysis (see Edhec (2003)). Since hedge fund indices can be considered as pseudo risk factors embedding the specific risk and return characteristics of alternative investment strategies, the interest of this methodology is twofold: first, it is return-based as opposed to portfolio-based, which is consistent with the low level of information investors have to cope with in the alternative universe, and second, it provides investors with full transparency as regards risk factor exposures. But again, since the different indices available on the market show considerable differences in terms of risk factor exposures (see Amenc et al. (2003)) the results of the style analysis will depend largely on the choice of the index provider.

The third objective of FoHF reports is to identify the fund's upside potential. Results from quantitative and qualitative analyses must offer an overview of both on- and off-balance sheet operations so that investors can see whether current performance is obtained at the expense of future returns. This would be the case if a fund decided to put its liquidity at stake by making excessive use of leverage. Such excesses can be identified by performing a Style VaR (see Lhabitant (2001)). Once again, the choice of the index will impact results.

The reason behind such heterogeneity between hedge fund indices is the lack of representativity (see Vaissié (2004a & 2004b)). The risk of making poor investment decisions due to bad index selection could thus be mitigated by constructing representative indices. This is what we will do in the next section of this article.

Constructing a series of representative hedge fund indices

Given that it is impossible to come up with an objective judgment on what is the best existing index, a natural idea consists of using some combination of competing indices to reach a better understanding of what the common information about a given investment style would be. One straightforward method would involve computing an equally-weighted portfolio of all competing indices. As competing hedge fund indices are based on different sets of hedge funds, the resulting portfolio of indices would be more exhaustive than any of the competing indices it is extracted from. We push the logic one step further and suggest using factor analysis techniques to generate a set of alternative indices that can be thought of as the best possible one-dimensional summaries of information conveyed by competing indices for a given style, in the sense of the largest fraction of the variance explained. This method is thus a natural generalization of the idea of taking a portfolio of competing indices. The refinement involves relaxing the assumption of an equally-weighted portfolio.

Technically speaking, it amounts to using the first component of a Principal Component Analysis of the different indices available on the market (see Amenc and Martellini (2003)). Note that the first component typically captures a large proportion of cross-sectional variations because competing styles tend to be at least somewhat positively correlated. The EDHEC Alternative indices (hereafter referred to as EDHEC Indices) are constructed according to this methodology.

To test the representative qualities of the EDHEC indices, we constituted an equally-weighted portfolio for each of the strategies from a proprietary database made up of 7,422 funds. The portfolios for the different strategies therefore contain more than 600 funds on average each, and as a result are considered to be relatively representative of their management universe. We then calculated the correlation coefficient of representative portfolios for the different strategies with the major indices publicly disclosing their data over the period from January 1998 to December 2000. The higher the coefficient, the more representative the index is. We classified the indices into three tiers. Indices with the highest coefficient are ranked in 1st tier indices and granted 3 points. Indices ranked in the 2nd and 3rd tiers get 1 point and 0 points respectively. We finally computed the average number of points obtained by each index provider. With 2.50 points on average, the EDHEC Indices turn out to be more representative than any other index (see Vaissié (2004b) for more details).

Paving the way for better investor information

Alternative investment strategies are highly sophisticated and data in the alternative universe is scarce. It is thus particularly difficult for investors to dispose of the real time information that they need to monitor their investments. In such a context, FoHF reporting turns out to be an essential tool. To serve their objectives, reports, however, must contain reliable and relevant information.

Using representative indices, such as the EDHEC Alternative Indices, clearly contributes to increasing the reliability of the information and removes an element of discretionary choice by the managers. In the same spirit, improving position valuation practices and imposing certification by independent third parties would also be two important steps forward.

Reporting must also provide investors with relevant information. Nevertheless, as evidenced in Edhec (2003) this is far from being the case. European multi-managers continue to provide investors with traditional indicators widely known to be inappropriate for hedge funds (e.g. 69% of European multi-managers consider the Sharpe ratio to be an important indicator). Many academics and practitioners are trying to address this issue by identifying indicators that take account of hedge funds’ special features (see Amenc et al. (2004)). There is consequently no doubt that FoHF reporting will progressively respond better to investors’ expectations in terms of clarity and quality.

References

Amenc, N. and Martellini, L., 2003, The Brave New World of Hedge Fund Indices, Working Paper, Edhec Risk and Asset Management Research Centre.

Amenc, N., Martellini, L. and Vaissié M., 2003, Benefits and Risks of Alternative Investment Strategies, Journal of Asset Management, Vol.4, N°2, p.96-118.

Amenc, N., Malaise, P., Martellini, L. and Vaissié, M., 2004, A Return Based Approach to Fund of Hedge Fund Reporting, Discussion Paper, Edhec Risk and Asset Management Research Centre

Edhec, 2003, Edhec European Alternative Multi-management Survey, Edhec Risk and Asset Management Research Centre.

Lhabitant, F.S., 2001, Assessing Market Risk for Hedge Funds and Hedge Funds Portfolios, Journal of Risk Finance, Spring 2001, p.1-17.

Vaissié, M., 2004a, Are Hedge Fund Indices Created Equal? (Part 1), Alternative Investment Quarterly, Q1 2004, n°10, p.27-33

Vaissié, M., 2004b, Are Hedge Fund Indices Created Equal? (Part 2), Alternative Investment Quarterly, Q2 2004, n°11, p.38-48