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Indexes
Hedge fund indices: a new way to invest in absolute return strategies?
Authors: Lars Jaeger
Source: AIMA Journal
Date: June 2004

This paper gives a succinct overview of hedge fund indices. According to the author, the heterogeneity of the indices is due to the heterogeneity of the construction criteria, such as weighting schemes or fund selection. He illustrates this heterogeneity by the fact that in 2003 the HFR Composite index displayed a return of 19.6%, which differed widely from the 11% displayed by the S&P Hedge Fund Index, even though those two indices are supposed to represent the same universe.

The shortcomings implied by averaging single hedge funds are underlined. Indeed, databases suffer from numerous biases, such as survivorship bias or selection bias. Moreover, the attributes of a good index are difficult to attain. Some indices are ambiguous due to the lack of transparency in their construction methods. Representativity is mitigated by the database biases and the difficulties engendered by the weighting scheme and fund selection. Measurement accuracy has to face up to the scarcity of reliable reporting. Investability, when a standard process is applied to select funds, engenders a cost at the representativity level, by excluding funds that are closed to new investments.

Focusing on theoretical shortcomings, hedge fund indexing suffers from the absence of a clearly defined theoretical foundation, such as Markovitz’s mean-variance framework in the traditional universe. From that angle, hedge fund indices are not prone to capturing the systematic risk of the hedge fund universe.

The author lists several practical challenges for investable indices. The definition of sub-strategies, the contents of the respective databases from each provider and the fund selection process are sources of discrepancies between investable indices. On the other hand, the weights of the sub-strategies can differ widely in composite indices.

Consequently, Jaeger concludes that there is a similarity between investable indices and funds of funds. According to him, investable indices are only a marketing argument used by the traditional providers to increase assets under management. He proposes two ways to test the reliability of investable hedge fund indices. Firstly, it has to be possible to construct derivatives on the basis of the index, and secondly it has to be possible to sell it short. Two methods are proposed for putting together a good investable index. The first approach consists of modelling the most generic risk premia, strategy by strategy. The second approach follows Fung and Hsieh (2003) {1}, through multi-factor models using what they defined as asset-based style factors.

Footnotes

{1} Fung, W., D. A. Hsieh, “Hedge Fund Benchmarks: A Risk Based Approach”, Financial Analysts Journal, forthcoming, 2004.