One of the prominent trends in hedge fund investing over the past five years has been the increasing participation of institutional clients who have not previously enjoyed any exposure in thisasset class. Whilst being gradually convinced of the merits of hedge fund investing, such clients have been examining ways and means of gaining exposure in a low risk and transparent manner.

One avenue, of course, has been funds of hedge funds, but here there remain transparency issues regarding the underlying funds, as well as cost issues in terms of the fees being charged. Some big investors are also concerned about liquidity problems, and the possible reputational risk that might ensue if a large investor, a pension scheme for example, is unable to unwind a position quickly enough. Every pension trustee’s nightmare is having his fund being named in connection with the blow-up of a risky investment scheme. It is no surprise then, that some of the most successful hedge fund-based investment products in the institutional market combine transparency with low volatility.

The launch by Royal Bank of Canada of its RBC Hedge 250 Index last year provided investors with a representative, highly diversified benchmark of hedge fund performance. RBC Capital Markets has approximately US$14 billion in hedge fund assets under administration, and has invested in over 1200 funds. Its custody and leverage business has been lending against hedge fund portfolios, making it the ultimate owner of those portfolios. All in all, the Canadian bank was in a good position to launch an investable index of this type, one devoid of selection bias, and which could provide investors with a decent replication tool for the hedge funds universe.

“There has been a great need in the market for an investable hedge fund index which does a better job of representing the asset class,” says Winston Ho, who helped to create the index at RBC. “We believe our proprietary process results in an index which is more representative than our investable indices, and as a result, will more accurately reflect the industry’s returns. So far, this conclusion has been firmly supported by its performance….Given the unique way in which our index functions, we strongly believe it has a persistent tracking advantage over the other investable indices and therefore will be a valuable investable benchmark.”

It came as no surprise when New Star Asset Management, itself a manager of US$2.2 billion in hedged assets out of a total asset base of US$49 billion, launched Hedge ETS in November last year. This was listed in London as a daily, tradable vehicle, with leveraged (3x) and normal shares. The aim was to provide investors with a highly liquid vehicle that would provide as broad an exposure to hedge funds as possible, with no style bias involved.

With over 250 funds represented, Hedge ETS compares well with investable indices (averaging around 90 funds) or the typical fund of hedge fund, with fewer than 70 underlying managers.

The RBC Hedge 250

At the heart of the New Star Hedge ETS product is the RBC Hedge 250 index, which covers nine distinct hedge fund strategies, and references actual funds, not managed accounts. RBC uses a selection process for the index that is designed to emphasise inclusiveness and minimise selection bias. Weightings and strategies are determined based upon RBC’s estimated strategy weightings of the hedge fund industry: at the inception point, the index had an approximately equal weighting, and is subject to monthly rebalancing. RBC is relatively transparent about its selection rules, which have been made available via a dedicated website at www.rbchedge250.com.

The RBC index can include funds that are closed to new investment, have limited capacity, and vary in terms of size and track records. The funds that represent the index today (now 257-strong) were screened from a ‘database of databases’ of 14,456 funds. Some 2000 candidate funds emerged from a universe of 5,739 vehicles, of which 400 were deemed to be eligible for the index.

A number of criteria were used to disqualify funds deemed unsuitable for the index. For example:

• funds of funds
• funds that could not be classified into a recognised index strategy
• funds that had ceased operations or were not providing sufficient data
• onshore funds
• those with less than $10 million in AuM
• no US dollar share class
• redemption notices in excess of 65 days

Funds were ranked in order of size, with no one fund permitted to comprise more than 1% of the index at best. This has led to a strategy weight picture which has inevitably left equity long/short as by far the largest component (37.4% on 31 May 2007), with multi-strategy second biggest at 15.2% (see Figure 1). Strategy weights have been established using 12 month rolling AuM data from the RBC universe, with individual strategy weightings subject to a cap. Fund weights are also subject to monthly rebalancing, with individual funds subject to a cap and floor. Funds may be added to the index to replace funds which have been removed and to achieve the target number of funds for each strategy.

The index has emerged with a slight bias towards funds in the US$100m to US$500m range, which reflects the industry-wide leaning towards funds of this size (they comprised 39.7% of the index at the end of May). Those over US$2 billion comprise 12.1% of the index, bearing in mind that there is an element of capping exerting its influence here, while those in the $10m to $100m bracket make up 13.6% (see Figure 2).

All this effort is meant to ensure that the RBC Hedge 250 Index will provide returns that represent the entire universe. The average fund in the index returned 9.58% in the 12 months to 30 April versus the average in the universe of 9.72%. These are the really important numbers. There is a big difference between top performers (40.8% in the index, 181.32% in the universe) and the basement boys (-24.53% index, -69.58% universe), but such extremes are not what this product is trying to access. The index beats the universe in the average second, third, and fourth quartile performance, and has fewer funds with negative returns.

The screening process has served to iron out many of the ‘blips,’ including funds with strategies outside the core recognised by RBC for the purposes of index composition, in its effort to provide a better mean product.

The important things to bear in mind, according to Ravi Anand, a director with New Star Asset Management, is that the index lacks the back-fill bias of some of the non-investable indexes, and has a lower Sharpe ratio (2.2 vs 2.5 for the average non-investable).

Hedge ETS

This product went out to the market in late November, marketed as a means to invest in the RBC Hedge 250 via conventional or leveraged shares (the 1x shares may have leverage of up to 25% for liquidity purposes). Hedge ETS procures its exposure to the index via swap contracts with the Royal Bank of Canada. It invests in a portfolio of cash and/or near cash instruments (rated at least AA/Aa2) in order to reduce the credit risk to the Royal Bank of Canada (itself the sixth-largest bank in North America and Aa2-rated on its own account). In Anand’s view, “the only credit risk is an unrealised gain on the index.”

Earlier in this article we mentioned the concern institutional investors have over liquidity and fees. Hedge ETS addresses both of these. New Star has tackled the liquidity issue by listing the fund as a security on the London Stock Exchange with daily liquidity. It is currently trading at an offer price of approximately 5.5% premium to NAV, with a discount management policy that would see the directors buying back up to 14.99% of the issued shares to manage supply/demand imbalances.

“RBC is taking the liquidity risk,” says Anand. “They have to deliver the returns of the index.”

As for fees, the 1x share class is charging 0.85%, while the 3x class is charging 1%. There is also an index fee of 0.95%, but given the lack of a performance fee, it still represents a very competitive means for an institution to acquire exposure to hedge funds as an asset class, particularly if the internal asset allocation committee currently lacks the time or experience to be dealing directly with funds of hedge funds.

Investors are not being given the benefit of 100% transparency, mind you. New Star points out that limited transparency in the application of the rules and calculation of performance is a risk consideration for investors, albeit a low one, alongside the liquidity risk in the secondary market for Hedge ETS shares for example.

RBC’s Alternative Assets Group

The RBC Hedge 250 Index has been developed by the bank’s Alternative Assets Group, a specialist division within RBC Capital Markets. It offers a range of products and services, including structured products, lending, and fund custody and administration, bringing it very close to a substantial part of the hedge funds universe. Formed in 1997, it currently comprises over 50 dedicated professionals based in New York and London. In order to support its hedge fund structured solutions business, the AAG has managed to develop significant relationships throughout the hedge fund industry, and is itself invested in over 1000 hedge funds. It has also worked to build robust in-house infrastructure and a pool of experience that has enabled it to emerge as one of the leaders in due diligence, risk analysis, transaction execution, portfolio administration, and valuation within this field.