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Investable Indices v. Funds of Funds

February 17, 2006 at 6:13 am

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Investable hedge fund indices have grown rapidly since 2003.PARA_BREAK_SENTINEL_9f8e7d6c

Investable hedge fund indices have grown rapidly since 2003. The major index compilers (MSCI, S&P, FT and Dow Jones) offer Investable Indices, as do providers who originate from the alternative asset arena, such as HFR and Tremont. Investable hedge fund indices are frequently presented as an alternative to actively managed funds of hedge funds. In this article the two approaches are examined, with a particular focus on the latter.

What funds of funds do

Funds of hedge funds are usually managed with the aim of achieving a specific rate of return with, in many cases, additional parameters based on volatility of returns and correlation to equities and bonds. Because many hedge funds are lowly correlated to each other and to markets, they lend themselves particularly well to portfolio construction. This feature means that leading fund of funds managers have developed expertise in structuring portfolios of hedge funds so that the portfolio volatility is much lower than that of the individual constituent funds.

As is evident from Figure 1, hedge fund strategies go through performance cycles and it should therefore be possible for a fund of funds manager to add value through dynamic strategy allocation. Also, Figure 2 shows that there is substantial potential for improving returns through manager selection, particularly in certain strategies. Funds of funds therefore tend to be managed through a combination of topdown strategy allocation and bottom-up manager selection.

A fund of funds can be viewed somewhat like a portfolio of equities with strategies being similar to market sectors and specific funds similar to individual equities. Although there is evidence of performance chasing in fund of funds management, both at the strategy level and the single fund level, a number of fund of funds groups have added value both through dynamic strategy allocation and through manager selection.

A fund of funds manager is only constrained in his opportunity to select from the vast pool of hedge fund talent by the fact that a number of funds are closed to new investment, and by the practical limits of his capability to identify, carry out due diligence on and monitor funds. Because the better funds of funds are respected by hedge fund managers, they can access funds which are not open to new investors, and moreover they entertain a dialogue with hedge fund managers which helps them to manage their portfolio to a higher standard.

Moreover, the larger fund of funds managers have developed expertise in risk measurement and risk management. Since many hedge funds do not provide full position level transparency, the risk assessment is based on an analysis of a fund's historical sensitivity to various factors, combined with the risk reports provided monthly by the funds.

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

YTD 2005

HFRI Macro
53.31%

HFRI Merger
Arbitrage
8.88%

HFRI Sector
39.65%

HFRI Sector
30.68%

S&P 500
33.3%

S&P 500
28.59%

HFRI Sector
67.00%

HFRI Merger
Arbitrage
18.02%

HFRI
Convertible
Arbitrage
13.37%

Lehman
Gov't/ Credit
12.10%

MSCI Indices
US World
30.82%

HFRI
Distressed
Securities
18.63%

Lehman
Gov't/ Credit
2.96%

HFRI Sector
33.71%

HFRI Sector
7.98%

S&P 500
37.54%

HFRI Event-Driven
24.84%

HFRI Equity
Hedge
23.41%

MSCI Indices
US World
22.79%

HFRI Equity
Hedge
44.22%

HFRI
Convertible
Arbitrage
14.50%

HFRI
Distressed
Securities
13.28%

HFRI
Convertible
Arbitrage
9.05%

HFRI
Distressed
Securities
29.70%

HFRI Event- Driven
14.18%

HFRI Merger
Arbitrage
2.29%

HFRI
Distressed
Securities
32.54%

HFRI Event- Driven
6.00%

HFRI Equity
Hedge
31.04%

S&P 500
22.92%

HFRI Event- Driven
21.23%

HFRI Equity
Hedge
15.98%

HFRI Fund
Comp.
31.29%

HFRI Relative
Value Arbitrage
13.41%

HFRI Event- Driven
12.18%

HFRI Macro
7.44%

S&P 500
28.67%

MSCI Indices
US World
12.83%

HFRI
Distressed
Securities
2.17%

HFRI Fund
Comp.
30.88%

HFRI Fund
Comp.
4.10%

HFRI Macro
29.32%

HFRI Equity
Hedge
21.75%

HFRI Macro
18.82%

Lehman
Gov't/ Credit
12.00%

HFRI Fund of Funds Comp.
26.47%

Lehman
Gov't/ Credit
13.27%

Lehman
Gov't/ Credit
9.40%

HFRI Relative
Value Arbitrage
5.44%

HFRI Sector
28.36%

HFRI Sector
11.59%

HFRI Event- Driven
2.10%

HFRI Event-Driven
28.22%

HFRI Relative
Value
Arbitrage
4.00%

HFRI Event-Driven

25.11%

HFRI Fund
Comp.
21.10%

HFRI Fund
Comp.
16.79%

HFRI
Convertible
Arbitrage
7.77%

HFRI Event-Driven
24.33%

HFRI Equity
Hedge
9.09%

HFRI Relative
Value Arbitrage
8.92%

HFRI
Distressed
Securities
5.28%

HFRI Event- Driven
25.39%

S&P 500
10.87%

HFRI Fund
Comp.
1.89%

HFRI Equity
Hedge
27.94%

HFRI
Distressed
Securities
3.84%

Lehman
Gov't/ Credit
22.74%

HFRI
Distressed
Securities
20.77%

HFRI Merger
Arbitrage
16.44%

HFRI Sector
7.62%

MSCI Indices
US World
23.54%

HFRI Event- Driven
6.74%

HFRI Macro
6.87%

HFRI Fund of Funds Comp.
1.02%

HFRI Macro
22.02%

HFRI Fund
Comp.
8.91%

HFRI Equity
Hedge
1.73%

HFRI Relative
Value
Arbitrage
27.10%

MSCI Indices
US World

3.34%

HFRI Fund
Comp.

21.50%

HFRI Merger
Arbitrage
16.61%

HFRI Fund of Funds Comp.
16.20%

HFRI Merger
Arbitrage
7.23%

S&P 500
21.03%

HFRI Fund
Comp.
4.98%

HFRI Fund
Comp.
4.62%

HFRI Merger
Arbitrage
-0.87%

HFRI Equity
Hedge
20.54%

HFRI Equity
Hedge
7.36%

HFRI Fund of Funds Comp.
1.09%

HFRI Fund of Funds Comp.
26.32%

HFRI Equity
Hedge
2.61%

HFRI Convertible
Arbitrage
19.85%

HFRI
Convertible
Arbitrage
14.56%

HFRI Relative
Value
Arbitrage
15.93%

HFRI Macro
6.19%

HFRI Macro
17.62%

HFRI Fund of Funds Comp.
4.07%

HFRI Fund of Funds Comp.
2.80%

HFRI Fund Comp.
-1.45%

HFRI Fund Comp.
19.62%

HFRI Fund of Funds Comp.
6.67%

HFRI Macro
1.00%

MSCI Indices
US World
20.38%

S&P 500
1.32%

HFRI
Distressed
Securities
19.73%

HFRI Relative
Value
Arbitrage
14.49%

HFRI
Distressed
Securities
15.40%

HFRI Relative
Value
Arbitrage
2.81%

HFRI
Distressed
Securities
16.94%

HFRI
Distressed
Securities
2.78%

HFRI Merger
Arbitrage
2.76%

HFRI Event-Driven
-4.30%

HFRI Fund of Funds Comp.
11.53%

HFRI Relative
Value
Arbitrage
5.29%

HFRI Sector
0.88%

HFRI Merger
Arbitrage
20.24%

HFRI Fund of Funds Comp.
-3.48%

MSCI Indices
US World
18.70%

HFRI Fund of Comp.
14.39%

MSCI Indices
US World
14.16%

HFRI Fund Comp.
2.62%

HFRI Relative
Value
Arbitrage
14.73%

HFRI Macro
1.97%

HFRI Equity
Hedge
0.40%

HFRI Equity
Hedge
-4.71%

HFRI
Convertible
Arbitrage
9.63%

Lehman
Gov't/ Credit
4.54%

HFRI Relative
Value
Arbitrage
0.39%

HFRI
Convertible
Arbitrage
15.22%

HFRI
Convertible
Arbitrage
-3.73%

HFRI Merger
Arbitrage
17.86%

MSCI Indices
US World
11.73%

HFRI
Convertible
Arbitrage
12.72%

HFRI Event-Driven
1.70%

HFRI
Convertible
Arbitrage
14.41%

HFRI Sector
0.31%

HFRI Sector
-4.90%

HFRI Sector
-12.85%

HFRI Relative
Value
Arbitrage
9.02%

HFRI Macro
4.09%

S&P 500
-0.82%

Lehman
Gov't/ Credit
13.20%

Lehman
Gov't/ Credit
-4.13%

HFRI Relative
Value
Arbitrage
15.66%

HFRI Macro
9.32%

Lehman
Gov't/Credit
9.87%

HFRI
Distressed
Securities
-4.23%

HFRI Merger
Arbitrage
14.34%

S&P 500
-9.09%

S&P 500
-11.85%

MSCI Indices
US World
-21.06%

HFRI Merger
Arbitrage
8.12%

HFRI Merger
Arbitrage
4.09%

MSCI Indices
US World
-1.75%

S&P 500
10.05%

HFRI Macro
-4.30%

HFRI Fund of Funds Comp.
11.10%

Lehman
Gov't/ Credit
3.35%

HFRI Sector
5.21%

HFRI Fund of Funds Comp.
-5.11%

Lehman
Gov't/ Credit
-2.40%

MSCI Indices
US World
-14.07%

MSCI Indices
US World
-17.83%

S&P 500
-22.09%

Lehman
Gov't/ Credit
5.07%

HFRI
Convertible
Arbitrage
1.07%

HFRI
Convertible
Arbitrage
-5.52%

The fund of funds managers' capability in risk management enables active management to avoid excessive concentration of a particular source of risk, e.g. emerging market equities, and to improve portfolio construction. The fact that the underlying hedge funds offer only moderate liquidity, typically one month to one year, means that risk monitoring is a particularly important task for a fund of funds manager.

In summary, funds of funds provide exposure to hedge fund strategies and, most importantly, to a selection of top investment talent within an actively managed portfolio which is monitored for risk.

Investable indices: a different proposition

Investable indices are a very different proposition. They are passively managed, sold on the basis of liquidity, transparency, low fees and a strategy weighting representative of the hedge fund 'asset class'. In order to achieve these objectives, the index provider invests in managed accounts across a range of hedge fund strategies, with the selection and monitoring carried out by consultants.

The approach thus appears straightforward. In practice it is not. Firstly, many hedge fund managers, particularly the largest ones, will not take on managed accounts, and secondly, certain strategies, for instance fixed income arbitrage and distressed debt, are difficult to access in liquid, daily priced, segregated account format.

The fact that the hundred largest managers, out of a universe of approximately five thousand, represent over half total hedge fund assets and are lowly represented in hedge fund indices, means that it is inevitable that investable indices do not provide a capitalisation-weighted exposure to hedge fund talent.

The Box plot shows the distribution of returns divided by quartiles.

The Box contains the middle 50% of the observed returns (the upper edge of the box indicates the 75^th percentile while the lower edge indicates the 25^th percentile).

The ends of the vertical lines indicate the minimum and maximum data values.

The 2 lines represent, respectively, 25% of the values, which are included between the maximum value, and the 75^th percentile and the remaining 25% of the values, which are included between the minimum value and the 25^th percentile.

What indices do offer is an exposure to hedge fund strategies. In order to provide this and to reduce manager risk, they are broadly diversified. In effect, they are structured to deliver the Beta of various hedge fund strategies. Accordingly, they will almost inevitably be impacted by systemic risk and hedge fund events. Funds of funds in comparison tend to be more exposed to manager specific factors.

It therefore seems likely that well-managed funds of funds will substantially outperform investable indices in spite of the somewhat higher fees. Indeed, the figures since the beginning of 2004, when investable indices first became substantial, are revealing, with the fund of funds indices (HFRI, Altvest, EDHEC), which reflect the performance of several hundred actively managed funds of funds, having delivered approximately + 10% over the 19 months to 31st July 2005, whereas the investable indices (MSCI, S&P, FTSE) were up approximately + 4% over the same period.

Conclusion: will Investable indices continue to outperform?

This underperformance of the Investable indices is in no way surprising, and may well be a price thought worth paying by investors who attach great importance to liquidity, and who view hedge funds as strategies rather than as talent-based investing. The question that may be asked if the investable indices continue substantially to underperform the universe which they aim to represent is whether providers - MSCI, S&P, FTSE etc. - should have put their names to the offering. After all, in the equity world it is the likes of BGI, State Street and Vanguard who provide index tracking funds, not the index compilers themselves. 쳌¡

Author : Prior to co-founding Fauchier Partners in 1994, Christopher Fawcett worked for five years with Euris SA, a large French investment holding company with substantial investments in private equity and Hedge Funds. He gained experience of the securities industry with Morgan Grenfell, with Industrial Technology Securities, a venture capital company of which he was cofounder, and with the Duménil Group.

Christopher Fawcett has an MA in Law from Oxford University, an MBA with distinction from INSEAD and qualified as a Chartered Accountant. He is Chairman of the Council of the Alternative Investment Management Association (AIMA), and a Director of Mirabaud Gestion SA. He is a Director of Fauchier Partners Ltd and a Partner of Fauchier Partners LLP.

Please click here to download the full hedgequest report The Global Reach of Investable Hedge Fund Indices