Those with a sceptical turn of mind can be forgiven for asking exactly what value all these new indices can possibly add to our knowledge of hedge funds. Surely, this must be game of diminishing returns. “The indices need to be clearly differentiated, ” warns Chris Mansi, a partner at Watson Wyatt Worldwide,” not all offer the same set of performance data or even measure the same set of hedge funds.”The variety and opacity of the underlying hedge fund universe are sufficient reason for this but other, purely commercial motives drive index providers.
Regardless of the type of indices sold by providers they can only draw on two main sources of revenue. The first, and traditional one is based on selling broad index data on a fee basis Over the last fifteen years this has been considerably refined with the introduction of customer specific,’dice and slice’ data provision. Screens for value or growth or socially responsible investment criteria are the most obvious forms of ‘dice and slice’; the same principle can be almost infinitely extended. Even so, there has been tremendous price competition among providers of broad index data and much of this data is now dumped free of charge into the market place.
But the core of competitive activity has been in buying, cleaning and selling price data derived from exchange or platform based transactions; price data at which equities, bonds or other instruments can be bought or sold. The quality of this data is crucial in less liquid asset classes such as non -sovereign bonds. With few exceptions, it is simply not available for hedge funds. The exceptions are hedge funds listed through exchange traded vehicles like investment trusts and they comprise a tiny fraction on the value of the total hedge funds universe. All that a broad hedge fund index can achieve is to measure returns by individual fund or by style peer groups.
So how else do index providers generate revenue? The answer is simple. Any product designed to replicate part or all of the return of an index and which uses it’s name for branding purposes will pay the index provider a licence fee. The exact terms of licence fee agreements are close guarded secrets, not least because some providers have such powerful brands that they licence the same index to more than one user. But the broad principles of these agreements are known; typically they include a flat fee with a commission based on the value of assets under management. Passive or tracker funds and exchange traded funds replicating the return of long only equity or bond indices already capture 30-40% of all monies invested against the FTSE All Share or S&P 500,yielding each index provider a rich and stable source of income. The same prospect beckons providers of hedge fund indices.
It is possible to roughly categorise the indices currently available under either of these models, although some function under both. Providers like CSFB/Tremont and Hedge Fund Research (HFR) are strongly positioned in the first category, and sell their broad index data on to providers like FTSE International who typically do not collect but simply refine such data. The process of refinement is all about finding investability and tradability. Broad indices include funds closed to new money, while narrow, investable indices will only include funds open to new money. If funds are open they can be replicated by one or another type of tracking or replicating strategy. Full sampling, running a tracker fund that re-invests investor monies into the underlying funds on a proportionate basis is the most conventional solution. A variety of alternative solutions using derivative products are also available. The key point is that for practical reasons investable indices can only offer access to a very limited number of hedge fund managers.
Matters are not improved with a more detailed look at the principles of construction behind each index. A large majority are equally weighted. Funds are allocated to strategy peer groups . Each receives an equal weighting in the index with performance per peer group rendered from the arithmetic mean of returns by constituent funds. “You have to ask how representative this approach of the underlying universe of hedge funds,” cautions Lars Jaeger of Partners Group. “Indexes built in this way only really measure themselves, their past performance.” That is not all. Only a minority of indices have transparent and consistently applied criteria for the inclusion or exclusion of managers and funds. Governance and due diligence are also an issue; half of providers do not have independent committees to oversee the selection process.
The age and accuracy of data in the indices also varies widely. Over half of index providers do not seek to verify data provided them by the underlying managers. This raises serious questions about the reliability of such data; a manager losing money has no incentive to reveal this fact, particularly if they are seeking to attract new investors. And even if the data is accurate it is always out of date by the time the indices compile and publish it. The normal time lag is four weeks or by the month. But even this varies by provider. HFR update on the 5th , and 15th day of the following month. CSFB update on the 15th day of the following month and MSCI offers estimated data during the month following with definitive data at the end of the second month. Most providers offer ‘flash data’ on a daily basis but this is nearly always revised at later dates and cannot be regarded as reliable.
The shortcomings of hedge fund indices do not end there. One of the strongest arguments is favour of buying index exposure derives from portfolio theory. A broad and representative index like the FTSE All Share or S&P 500 is an efficient portfolio, capturing optimal risk and return characteristics for investors who want market exposure. But hedge fund indices do not possess this set of properties. Start with the number of funds in each provider’s data base. Van Hedge holds over 5,400, HFR over 2,300 and MSCI only 1,800. Most providers claim to run proprietary data bases but some like Edhec and FTSE buy this data from other providers. More importantly, the number of funds in providers’ indices, a sub set of the total in their data bases, can also vary widely. Van Hedge includes 1,300 funds, HFR over 1,400 and MSCI over 1,500. Feri , FTSE and S&P include far smaller numbers falling in the 30-50 range. With so much variation, it is hard to see the point of comparing these indices.
Not surprisingly, there is little uniformity in the method by which funds are placed in style peer groups. MSCI generate over 190 separate indices from their database, HFR some 37, Bernheim only one. Classification is sometimes left to the manager ,sometimes to the index provider. The minimum conditions to be met before a fund is admitted to an index also vary widely and are sometimes not made public. HFR impose no minimum threshold for assets under management, but CSFB and MSCI both require $15 m or more, while funds admitted to S&P’s index must be worth at least $75m. Most providers do not require admitted funds to have run for a minimum period, but EACM and FTSE require two years, and S&P at least three years. Some indexes include the past returns of funds that have currently ceased trading, others of funds that are closed to new investors.
There must be reasons fundamental to hedge funds that explain the diversity of these indices. And by comparison, there is less and less difference between the major indices for exchange traded equities and bonds. Here lies a vital clue. In these traditional asset classes, the average return from the relevant indices fits very neatly with portfolio theory. If the index captures all the investable securities in that class ,weighted by value, then it also represents the combination of assets with the optimal trade off between risk and return in market equilibrium. This allows investors to buy the risk of the whole asset class captured by the index without accepting manager specific risk. It also opens the way to the application of concepts like ‘portable Alpha’.
But none of this is available through the hedge funds indices. These measure the median performance of arbitrarily selected groups of hedge funds. There is no reason why such portfolios should be optimal ones and as a consequence no reason why they should capture market risk for the broader hedge fund univers. “This is why they are of no use as performance benchmarks for hedge fund managers,” thinks Robert Howie , a partner at WM Mercer Investment Consulting,” cash plus or LIBOR plus are possibilities but much depends on the strategy used by the fund being benchmarked. In the case of equity long/short the optimal benchmark might just be along only equity index.” In fact, the new hedge fund indices have started to look more and more like fund of fund products. “And this raises serious issues for investors,” cautions Leola Ross, head of hedge fund research at the Frank Russell Company,” for instance how consistent in the due diligence carried out by the index provider and how well do they monitor issues like style drift within the underlying portfolio.”
Not surprisingly , FTSE International’s hedge fund index is based on just the licence fee model for revenue generation. FTSE buy raw data from other index providers including CSFB/Tremont and Hedge Fund Research, then sieve and clean this to produce a short list of just 40 management companies. These include some illustrious names of which just three are Arnhold& Bleichroeder Inc., RAB Capital , and Winton Capital Management. But the FTSE Hedge index hardly looks representative of the total hedge fund universe. It is all about investability. “There is not much point in including both open and closed funds,”says Paul McLean, the product’s marketing director,” because that is of little use to index users.” In fact , ‘closed’ hedge funds often ‘open’ but only to a client with the right ,usually large amount of capital. FTSE expect all the funds in their index to be open at least to the FTSE Hedgehx Fund, which is designed to track the index by full sampling of the underlying constituent funds. The criteria used by FTSE for inclusion in this index includes assets under management of £50m or more and at least two years of investment returns for each fund. They also use a novel formula for estimating capacity by sector; the average size of ‘open’, constituent funds is compared to the average size at which all funds in the same sector close to new money. The difference is then multiplied the number of funds in the index for that sector to give an estimate of capacity.So what use will the FTSE Hedgehx Fund be to FTSE clients? “If you have money ready to go into hedge funds this is a good place to park it,” says McLean, ” and we expect some investors to use it on a long term basis.”