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Hedge fund indexing: a square peg in a round hole? Authors: A. Kohler Source: State Street Global Advisers Investment Insights Date: June 2003 |
This paper highlights the difficulty of implementing an index-based approach in the hedge fund industry. A distinction is made between the theoretical shortcomings and the practical challenges. Due to the specific characteristics of the hedge fund industry, hedge fund indexing is not a simple application of the methodology used in the traditional universe.
Considering the theoretical shortcomings, the weighted-average return obtained through an index is valid only if assets are priced by market participants. This is not the case for hedge funds, and consequently weighting is subjective. Moreover, the notion of index implies a diversification where the alpha generated by the skilled managers is mitigated by the unskilled managers. This passive investment approach conflicts with the active hedge fund universe.
Considering the practical challenges, the variety of methodologies used to construct the indexes among the providers illustrates that there is no optimal methodology admitted by all index providers. The quality of an index depends on 5 parameters: accuracy, completeness, transparency, investability and low turnover.
Nevertheless, achieving these 5 parameters at the same time is a challenging task. It is illustrated for example by the incompatibility of two of these goals, completeness and investability. While completeness requires that open and closed funds be considered, only open funds are investable.
Consequently, the resulting indexes are a compromise between the five parameters. In other words, among the various index providers, the importance that is given to each attribute differs. This explains the fact that the return series exhibited by the different hedge fund indexes do not display a correlation of 1. For example, based on the returns from January 1998 to March 2003, the correlation between Hennessee and the S&P Hedge Fund Pro-Forma Index is 0.66, and between TASS and the S&P Hedge Fund Pro-Forma Index is 0.67.
The implementation of a passive investment strategy, i.e. an index-based approach, is problematical too. Following this strategy, the weight of each hedge fund in the portfolio has to be the same as in the target index. This requires efficient rebalancing in the portfolio, but is rendered impossible by lock-up periods, for example. Moreover, the lack of synthetic substitutes prevents investors from getting round the problem. Under these constraints, according to the author, it is particularly difficult to follow a passive investment strategy in the hedge fund universe.
