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EDHEC's Position on the Eligibility of Hedge Fund Indices for UCITS

In September 2006 in a document entitled "A Reply to the CESR Recommendations on the Eligibility of Hedge Fund Indices for Investments of UCITS", Noël Amenc and Felix Goltz of EDHEC-Risk Institute urged the CESR (Committee of European Securities Regulators) to reconsider their position on suspending the eligibility of hedge fund indices.

EDHEC-Risk addressed the different questions that can be raised on the quality of an index. In terms of diversification, the authors point out that it is more important for hedge fund indices to be representative than diversified, but that global hedge fund indices are more diversified than global equity indices. For strategy hedge fund indices, EDHEC-Risk also observe that the diversification results are better than for style or sector indices in the equity world, even though the latter have been approved by the regulators.

As far as transparency is concerned, the implementation of managed account platforms renders hedge funds just as transparent as traditional mutual funds.

The authors also wonder why hedge fund index providers should be required to publish the complete fund-by-fund composition of their indices, when this is not required of indices in other asset classes.

Finally, due to a lack of official recognition, hedge fund indices do not have the status of a major reference for most hedge fund or fund of hedge fund managers. The authors affirm that hedge fund indices need to be recognised as genuine references so as to be used as benchmarks and enable investors to have a better understanding of the real risks of hedge funds.

In December 2006, EDHEC-Risk again condemned "discrimination against hedge fund indices" in reply to the CESR Issues Paper on the eligibility of hedge fund indices for the purpose of UCITS. In a paper entitled, "Hedge Fund Indices for the Purpose of UCITS: EDHEC Answers the CESR Issues Paper", EDHEC-Risk Institute argues that hedge fund indices should not be required to offer more controls and more transparency than existing financial indices such as stock market indices.

In a series of answers to the questions put forward by the CESR, EDHEC-Risk also insist that the construction of hedge fund indices should not be subjected to detailed rules for choosing constituents and implementing rebalancing and weighting mechanisms.

Rejecting hedge fund indices seems to be inconsistent with the treatment of indices for other asset classes which face the same types of problems as hedge fund indices. A more promising approach, according to EDHEC-Risk, would be to accept hedge fund indices in principle and to require a number of quality criteria, including:

  • Transparency of the method
  • A methodology that guarantees a high degree of representativity as well as precise classification of components (such as factor analysis)
  • Minimum liquidity of the indices
  • Investability of index components
  • Prohibition of practices such as backfilling
  • Information on risk factor exposure
This alternative seems to be more convincing than to either reject hedge fund indices on the basis of their shortcomings or to make all hedge fund indices eligible without considering the specific quality of each index. Widespread use of high quality hedge fund indices for investment and risk analysis would mark an important step towards proper information for investors on the level of risk in hedge fund products.