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Alternative Investments - May 12, 2005

EDHEC creates 5 investable indices: the EDHEC Investable Hedge Fund Indices

In spite of the recent advances in hedge fund indexing, designing good hedge fund indices remains a particularly challenging task in the face of challenges that are specific to the alternative investment industry. Two distinct purposes have to be distinguished: i) an index can be used as a benchmark for investments in specific styles, instruments or locations; or ii) it can be used as an investment vehicle. Each of these two purposes is associated with some challenging construction requirements. In particular, indices that act as benchmarks have to be representative, i.e., they should accurately reflect the whole universe of hedge funds following a particular style. On the other hand, indices that act as investment vehicles are obviously required to be investable in addition to being representative.

In 2003, EDHEC proposed an original solution to the challenge of representativity by introducing a set of alternative indices (known as the EDHEC Alternative Indexes1), which can be thought of as the most representative possible portfolio of hedge fund returns for a given style, based on factor analysis of competing indices.

In 2005, EDHEC has adapted the methodology behind the EDHEC Alternative Indexes to propose a solution to the challenge of investability and offer a set of investment vehicles (known as the EDHEC Investable Hedge Fund Indices) while maintaining a focus on representativity. These indices, which are made up of a limited number of single hedge funds, can be thought of as the best possible one-dimensional summaries of information conveyed by a variety of hedge funds following a given style, in the sense of the largest fraction of the variance explained. Since they are both representative and investable, these indices are ideal tools for constructing asset allocation benchmarks.

The EDHEC Investable Hedge Fund Indices are invested in funds that are managed on the Lyxor (Société Générale group) managed accounts platform, which allows them to benefit from a secure and liquid investment context. Their performances will be calculated every week and their liquidity is also weekly.

The EDHEC Investable Hedge Fund Indices are not funds of funds and as a result are not marketed as such. They are allocation supports that allow asset management firms or institutional investors to implement value creation strategies based on dynamic allocation between the hedge fund styles. Up until now, the stumbling block for implementing an effective allocation policy in the alternative universe has been the lack of investment supports that are liquid and genuinely representative of the risks of each strategy. To date, five EDHEC Investable Hedge Fund Indices have been created, covering five popular strategies, namely, Convertible Arbitrage, Equity Market Neutral, Long/Short Equity, CTA Global and Event Driven. These strategies not only represent the bulk of assets managed in the alternative arena (i.e. 65%)2 but they also deliver betas that are representative of the hedge fund universe.

First example of this new form of value creation: the Equity Diversifier and Bond Diversifier mutual funds from the firm Lyxor. These funds of funds, which will be marketed in France from May 11th, are based on an optimal combination of EDHEC Investable Hedge Fund Indices with a view to diversifying equity or bond portfolios.

Other funds of funds that are based on EDHEC Investable Hedge Fund Indices are currently being prepared. Through EDHEC Investment Research, its asset allocation consulting activity, EDHEC supports asset management firms in the design and use of the dynamic multi-style, multi-class allocation method that is one of the EDHEC Risk and Asset Management Research Centre’s major research areas.

In September 2005, more than 5 alternative funds of funds whose performance will be based on allocation between EDHEC Investable Hedge Fund Indices should be created by European asset management firms.

Footnotes:

1 The EDHEC Alternative Indexes are indices of non-investable hedge fund indices, which are consequently non-investable themselves.

2 According to major hedge fund database providers (e.g. TASS, HFR) Convertible Arbitrage, Equity Market Neutral, Long/Short Equity, CTA Global and Event Driven represent respectively 8%, 7%, 32%, 5% and 13% of the hedge fund universe, as of the end of 2004.