For investors managing over $1 billion,
Are Hedge Fund Indexes the Answer?
October 31, 2007, 7:41 am
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Indexes have long been used as a gauge of performance for stock and bond investors, but, Investment Dealers’ Digest wonders, can they be used within the hedge fund industry, and could they supplant the role of funds-of-funds that many institutional investors have come to rely on?
Indexes serve as barometers for an industry or an asset class, and in recent years Wall Street firms such as Credit Suisse and Barclays Capital have introduced hedge fund indexes. These indexes look to measure the returns of a broad pool of hedge funds to establish an overall peer group performance benchmark.
Proponents of hedge fund indexes believe they can be cost-effective and save time for investors. But, notes I.D.D., there has been a mixed reaction among investors to these indexes, some whom believe that basing investments on the index can only generate average returns.
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Can Hedge Fund Indexing Work?
Indexes have long been used as a gauge of performance for stock and bond investors, but can they be used within the hedge fund industry, and could they supplant the role of funds-of-funds that many institutional investors have come to rely on?
Indexes serve as barometers for an industry or an asset class, and in recent years Wall Street firms such as Credit Suisse and Barclays Capital have introduced hedge fund indexes. These indexes look to measure the returns of a broad pool of hedge funds to establish an overall peer group performance benchmark.
According to a recent Credit Suisse report, institutional investors will measure a hedge fund’s performance by measuring it against a risk-free rate of return such as cash plus a certain number of basis points. Another way to gauge how well a hedge fund is doing is to measure its performance against public equity markets. Now, though, hedge fund indices look to measure performance of a hedge fund by measuring how well it does against its peers.
“Over the last decade, funds-of-funds were widely popular with investors because they were overwhelmed with the choice of which hedge funds to invest in,” says Philippe Schenk, director at Credit Suisse. “Within the past three years, more and more investors are looking into indexed funds, and the strategy is starting to establish itself in the marketplace,” he says.
According to Ferenc Sanderson, senior research analyst at Lipper, a debate is ongoing among large institutions as how to best invest in hedge funds. Institutions like endowments or pension funds can invest “passively” using a hedge fund index or they can do the research themselves and find a fund with an investment strategy they like. Or, they can hire a fund-of-funds to put their money to work for them.
Proponents of hedge fund indexes believe they can be cost-effective and save time for investors. “It is difficult for investors to pick from a universe of over 10,000 hedge funds,” says Schenk. He adds that finding top managers in the industry requires resources and time because of a lack of transparency in the industry and the variety of trading strategies.
Using a hedge fund index, “allows for smaller fees, greater diversification, and stronger risk adjusted returns,” according to Schenk, who is with Credit Suisse’s alternative investment group, and co-author of the bank’s recent report “Gaining Efficient Hedge Fund Exposure through Passive Investing.” “It also eliminates the subjectivity of actively managed funds providing consistent return patterns,” he says, conceding that some investors will always prefer to actively manage their investments within hedge funds.
Credit Suisse unveiled its Credit Suisse/Tremont Hedge Fund index in 2003. The index tracks 455 funds with a combined $656 billion in assets under management.
According to that recent report published by Credit Suisse, “with an indexed portfolio, an investor ‘buys’ the entire market, creating safety in numbers. Should an individual hedge fund experience management or trading problems, the impact to the overall portfolio is minimized.”
Hedge fund indexing, though, has encountered some skepticism. There has been a mixed reaction among investors to these indexes, says Sanderson, who points out that “there is no specific universally recognized benchmark for hedge funds.”
Charles Gradante, managing principal and co-founder of New York-based investment advisory firm Hennessee Group, believes that hedge funds indexes “can be overly diversified to the point where it generates average returns.”
Gradante is not convinced that putting money to work in hedge funds using indexes is the most effective way to use capital. Also, he would not allocate more than 10% of a portfolio using a hedge fund index. “Hedge fund indexing is a great idea and works on paper, but hasn’t worked in the marketplace to any effective degree,” he says.
For investors managing over $1 billion, Gradante sees some benefits in using hedge fund indexes. But, “if an investor has $100 million, a better option is to leave money in funds-of-funds where the portfolio can reflect their opinions of the market easier,” he said.
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