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Investable hedge fund indices might well offer increased liquidity and transparency – the drawback is that they are not truly representative. The whole point of hedge funds is to get access to additional alpha provided by skilled managers, which is not the same as the performance of the average manager. Hedge funds are about absolute return per unit of risk, not about index tracking.
René Herren, head of structured client solutions at Man Investments, attributes index-based product sales to the strength of index branding. “They’re selling S&P or MSCI rather than hedge funds,” he says. Man considered creating its own hedge fund index but decided against it because it lacked an “index brand”. “For liquidity and transparency you don’t need an index,” he says. “The RMF Transparency fund, for instance, provides exactly the same information and liquidity as an investable index.”
A key constraint on investable hedge fund indices is that the underlying constituents must be open to new investment. This restricts the funds that can be included. Many of the best performers are closed. And most index-providers require their managers to run managed accounts alongside their own hedge funds and take the same positions, replicating the hedge fund. This can be cumbersome and costly for managers and so many feel it deters larger and more successful funds from participating.
Man’s Herren says: “A manager with a successful five-year track record has no real interest in setting up a managed account for an investable index.” He also believes the liquidity required by indices limits the strategies. He adds: “[Indices] are not necessarily negative but investors need to think about what’s important. For example, if they want weekly liquidity.”
Index providers such as HFR, MSCI, S&P and Dow Jones use managed accounts to give them a transparent view of the underlying funds. For example, Lyra Capital’s CEO Garry Crowder says: “We create a platform of managed accounts. Every manager on the platform manages a managed account that Lyra owns. Therefore we have transparency down to the Cusip level.” He adds: “Of the managers we actually want [in the index] we probably lose in the neighbourhood of 2% to 3%.”
Some players are critical of the fact that these indices appear to be quasi-actively managed funds. Man’s Herren says: “Most indices are more like funds of funds. They’re managed like a fund of funds but they don’t select components based on performance.” He adds: “They do the due diligence which is active but they do not look at performance. They just want to be average.”
CSFB/Tremont has taken a different tack. Its funds are selected from the 400 in its non-investable hedge fund index, as measured by assets under management. They are the six largest eligible funds in each of the 10 strategies covered.
Many feel inconsistency of returns in different indices shows they are not truly representative of the wider fund universe (see chart). The different performance of investable and non-investable indices hasn’t helped either. With CSFB/Tremont, says Oliver Schupp: “Most of it is to do with the different sector weightings in the two indices. The investable index is a bit more broadly diversified.” It also includes closed funds.
