Measuring the Measurable…

...and not an inch more!

Kevin Pilarski, Director of Alternative Strategies, Dow Jones Indexes
Originally published in the August 2005 issue

As it passes the $1trillion asset milestone, the hedge fund industry is growing up fast, thanks in part to new tricks learned from its older, traditional asset management siblings. How else to explain the growth spurt seen in investable hedge fund indexes, a passive representation of the world's most active managers?

Just a few years ago, the idea that hedge funds could become part of any passive investing approach was laughable. Nevertheless, those with long memories will recall that passive investing itself took years to catch on. Investors initially shunned John Bogle's 1976 gambit to launch the first indexed mutual fund. However, as with hedge funds today, the logic of the approach took hold, as investors recognized the ease of risk control, lower fees and portfolio transparency indexes could provide. And just as it occurred 20 years ago, once institutional investors saw the light, the trickle of assets entering the market grew to a torrent.

Now hedge funds are walking this well-worn path. Originally the province of a small group of investors, they are now the playgrounds of large pension funds, banks and other institutions clamoring for new ways to diversify portfolios. The notion of an asset class that is all about the alpha has proven too strong a temptation to resist, and hedge funds have responded in spades. The number of funds has ballooned to an estimated 8,000 with no end in sight. In addition, while no one suggests handcuffing a manager's creativity, it is now possible to capture a subset of the hedge fund universe in an attempt to measure and understand what is going on. Hence, the birth of the hedge fund indexes.

Today, hedge fund indexes stand at the crossroads of the evolution in both indexing and hedge fund investing. The riddle is how to measure a market that resists categorization. Some have argued that a single number can represent the performance of the hedge fund industry. However, that makes as much sense as the man with his head in the oven and feet in the freezer: on average, the temperature is just fine.

Looking at YTD returns as of mid-year, if convertible arbitrage is down 6.5%, while event driven is up 3.5%, investors are looking at about 10% return difference between just two of the strategies. Global macro provides a similar problem, given the little common ground pork bellies and oil share in the global soup.

Measuring only what is measurable

Dow Jones Indexes' philosophy is to measure what is measurable and not an inch more. Yet, as a wise chef carefully selects his ingredients and uses the most precise instruments to measure them out for a dish, investors should take great care in examining what goes into an index. Hedge fund indexes may not provide access to every sliver of this burgeoning asset class, but they absolutely must be reliable, transparent indicators and tools where deployed.

The world's investors can view hedge funds as widely grouped into four basic categories: relative value (equity market neutral, bond hedge and convertible hedging); event driven (merger arbitrage and distressed); hedged equity (US, European, global and sector); and macro (traders who make directional trades in global equity, fixed income, currency and commodity markets). Each of these strategies strives for an absolute return, rather than a return relative to a particular index, through skills-based investment strategies. In this way, hedge funds typically offer low correlation with stock and bond portfolios and hence, potential diversification benefits.

As with any index, investors demand asset and risk management processes that are consistent with the investment standards applied to managing traditional equity and fixed income investments. An investable hedge fund index should be formulated using quantitative methods in concert with ongoing qualitative due diligence. Strategy style-purity is an important prerequisite to providing consistent and representative strategy -based returns in various market environments. Each benchmark should represent a portfolio of managed accounts that reflect the returns and risks of a specific strategy. We accomplish this by using a portfolio of approximately six to 10 'style pure' managers that capture the risk and return characteristics of a style pure portfolio within a selected strategy.

Too few managers representing each strategy might result in excessive volatility in a benchmark, because the manager-specific risk remains concentrated, lacking proper diversification. Too many managers would be too costly to administer and monitor, negating the economics of these instruments. Six to 10 constituents are optimal. At present, there are 40 managers across the six Dow Jones strategies. Each benchmark is equally weighted among its component managers to minimize the chances of one manager's performance skewing the performance of the benchmark.

The use of separate accounts for each hedge fund further offers the investability, measurability, transparency and risk controls required by institutional investors while providing the ability to report daily returns. The names of all hedge fund managers are publicly available. Finally, investors have access to daily valuations of the benchmarks to ensure transparency.

Selecting component managers

Benchmark component selection is also crucial, and guided by three principles. First, the manager must be able to credibly show and have established the capability of executing the "core" business of managing a portfolio and generating performance. Style purity is essential and a manager must have the investment infrastructure necessary to support its business.

At Dow Jones Indexes, for example, manager selection starts with publicly available databases and other information sources. Minimum qualification criteria include a minimum track record of two years and a minimum of $50 million under management although our average manager has $900million in assets. The performance of cluster and other quantitative analyses partitions the data into sets of similar members, eliminating outliers

Maximum leverage limits are imposed on the constituent managers. Leverage restrictions are consistent with the typical leverage used in each strategy and do not degrade the risk-adjusted performance of the benchmark. Finally, an advisory committee consisting of leaders in the hedge fund community actively reviews the benchmarks.

The results in this case are six Dow Jones Hedge Fund Strategy Benchmarks, selected from among the wide range of hedge fund styles and strategies for their unique features. Each strategy has known style attributes and known exposures to market factors; each has an inherent return stream. In each strategy, managers will differ somewhat in trading style and asset management approach. However, for the six strategies, selected the managers' common strategy characteristics drive the returns.

The six strategies include equity market neutral, convertible arbitrage, distressed securities, merger arbitrage, event driven and equity long short (US). Common market risk factors are attributable to each. In convertible arbitrage, for example, the return streams can be decomposed into four factors: credit risk, implied volatility risk and to a lesser degree, term structure of interest rates and equity beta or systematic stock market risk. Remembering our pork bellies and oil conu -ndrum, there is no global macro strategy index.

A competitive option?

When compared to the average fund of funds, investable hedge fund indexes produce competitive returns within a lower fee structure. Lower performing funds of funds may find increasing competition from the hedge fund indexes. Interestingly, fund of fund managers are using the indexes to equitise excess cash in the same way that active equity managers will purchase ETFs because it is much easier than performing due diligence on new managers and provides easy instant access to strategy return streams.

On a cautionary note, fee issues may arise for the fund of fund community when their equitisation activity in passive hedge fund indexes becomes more widely known.

Hedge fund indexes have enjoyed wide appeal among institutions that are used to having full transparency in their traditional portfolios, and are employing "core and satellite" allocations. They have also become popular with firms that sell structured products and thus need an accurate daily net asset value for consistent risk management procedures.

As with traditional passive investing and the derivative innovations that followed, hedge fund indexes will stimulate advances in hedge fund market access. Already, investors are using them to synthetically gain exposure to sector baskets or market factors, thanks in part to the growth in the credit default swap market. By example, an investor holding a convertible arbitrage strategy, could hedge his credit exposure with a credit default swap contract on the Dow Jones CDX index while still remaining with a long exposure to volatility risk, interest rate risk and equity market risk. Shorting type strategies that enable risk transfer will become a reality. Banks are already offering OTC options on hedge fund strategies, and we are sure to see similar innovative trades with the continued growth in capital guarantee products.

Hedge fund indexes represent a sea change in hedge fund investing. Properly attuned to the strategies they track, these benchmarks will not only lay bare the opacity of the hedge fund industry, but also provide a foundation for significant financial innovations. More products, more choices, more ways to measure and access the market, advance the science of risk management, and ultimately create a future rich with opportunities. You can bet on it.