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François Duc, Ph. D.

Investable Hedge Fund Indices:Illusion or reality?

August 2004

Many academic papers have tackled the failure of non-investablehedge fund indices to efficiently represent the universe of hedgefunds (for a survey see for instance Duc, 2004). Indeed, hedge fundindices display such a high level of heterogeneity that it cannot bestatistically concluded that they track a common phenomenon. Incontrast, traditional indices such as the Dow Jones or the S&P 500,despite some differences in construction and composition, do notexhibit significant differences and statistically represent the samemarket, namely the US stock market. In the case of hedge fundindices, the value of each index is determined more by itscomposition than by an average performance of the alternativestrategies that would be common to all hedge fund indices.

In this article, we will focus on investable hedge fund indices. In thesame way as their non-investable counterparts, they aim to providean average picture of the hedge fund universe, with the added

constraint of exclusively including open hedge funds in theircomposition, and are thus subject to the same lack of representativeness. Promoters of investable indices firmly disagreewith this point of view and argue that they provide a higher qualitystandard than non-investable indices. Obviously, creating a portfolioof hedge funds in which it is possible to invest is more demandingthan managing a theoretical index. While it is certain that animprovement in the quality of representativeness should cause hedgefund selection bias to decrease or, similarly, for heterogeneitybetween indices to diminish, this is unfortunately not the case.

HIGH HETEROGENEITY BETWEEN INVESTABLE INDICES

In terms of strategy allocation, the various investable indices are verydifferent. As of November 2003, the comparative analysis of fourinvestable indices (CSFB/Tremont, HFRX, MSCI, S&P) with respect tothree broad categories of alternative strategies reveals widedifferences in strategy exposures: Macro/CTA exposure variesbetween 13% and 22%, Long/Short exposure between 13% and45%, and Arbitrage/Relative Value between 38% and 67%.Investable indices also differ substantially as regards the selectedmanagers that compose the index portfolio. Of the 159 managerscovered in total by the S&P, CSFB/Tremont and MSCI indices atNovember 2003, only 14 (i.e. 9%) were selected in more than one

index, and only 2 were included in all three indices. On average, theintersection between two investable indices ranges between 5% and



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20%, whilst the intersection between 2 large databases rangesbetween 37% and 59%.

Moreover, within a given strategy, investable indices differ not only interms of weightings and of manager names, but also in the way thatthe selected managers implement the strategy. This heterogeneity

results from a selection process that is not geared to chooserepresentative managers, but hedge funds that are expected togenerate high performance. Without going into detail and explainingthe difference between each manager, three elements from the actualmanagement of investable indices illustrate this feature.

First, there are some hedge funds that apply a pure approach of agiven strategy, such as, for instance, systematically investing in allannounced mergers and acquisitions. This kind of approach can beseen as a naïve way of implementing the strategy and may be usedas a good proxy for a passive strategy index. But, during favourableperiods, managers using a naive approach tend to underperformthose applying a more selective approach within the same strategy.As a result, such open hedge funds, despite their goodrepresentativeness of the strategy, are never included in anyinvestable index.

Second, the aggregated underlying positions of all the hedge fundportfolios included in the Dow Jones Convertible Bond Index, which isan investable index, has sometimes demonstrated characteristics of reverse trades, exhibiting a short bond exposure and a long equityexposure. This typically neither reflects a pure strategy nor theaverage approach of convertible managers.

Third, the actual management of investable indices does not seem

compatible with the representation of a pure strategy. At the end of February 2003, the GLC Gestalt Europe Fund replaced the JemmcoFund in the S&P Index. Both managers follow statistical arbitragestrategies, but GLC Gestalt Europe specialises in pair trading onEuropean stocks, whereas Jemmco applies several statistical models(including one pair-trading model) to mainly US-based equities.Hence it is difficult to comprehend how these two hedge funds canrepresent the same mean approach to a pure strategy or induce thesame diversification effects. Note that the Jemmco Fund has recentlyceased activity, which tends to prove that the fund was excluded forquality reasons and not for representativeness issues.

In fact, the efforts deployed for compiling investable indices are notfocused on representing the universe more efficiently, but onimproving the quality of the underlying managers. Selecting hedgefunds because of their expected quality will expose investors to astrong hedge fund selection bias. This bias, combined with non-homogeneous strategy allocations and with their smaller size, willimply a larger heterogeneity between investable indices than betweennon-investable indices. Figure 1 compares the maximum difference inactual monthly returns of investable indices with that of non-investable indices for 5 different strategies. Generally, the trackingerror between investable indices of the same strategy is much higherthan the one between non-investable indices.



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1.5%1.3%

3.7%

2.0%

1.2%

0.6%

2.9%

1.3%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

Long Short Macro Convertible Market Neutral

Maximum absolute differencebetween investable CSFB/HFRindicesMaximum absolute differencebetween non investableCSFB/HFR indicesAverage absolute differencebetween investable CSFB/HFR

indicesAverage absolute differencebetween non investableCSFB/HFR indices

Figure 1

INVESTABLE INDICIES: NOT MORE ATTRACTIVE THANFUNDS OF FUNDS

As they are not built to represent the universe but to yield highreturns, as they convey an important exposure to manager selectionand as they are more heterogeneous than their non-investableversion, the so-called investable indices are in fact funds of funds.Promoters of such indices argue, however, that investable indicesoffer four main advantages as compared to other funds of funds: 1.portfolio management is unambiguous, 2. heterogeneity betweeninvestable indices is smaller than that between other funds of funds,3. investable indices are more profitable, 4. liquidity featured by

investable indices is higher. Reality shows that the first threeadvantages are not accurate and that the last one is provided at ahigh cost either in terms of fees or risk. Our arguments are givenbelow.

Firstly, weightings within index portfolios are not so unambiguous asthey are in fine provided through biased samples, however large adatabase or subset is considered. Moreover, the actual managementof investable indices render the weightings questionable. Forinstance, during the “Investor Fachtagung Funds of Hedge Funds” conference organised in June 2004 by the Transparency CouncilFunds of Hedge Funds, Stephan Ewen pointed out that the equally-weighted average performance of the strategy indices was not equalto the performance of the HFRX Equally-Weighted Index fromFebruary to May 2004. Moreover, Stephan Ewen expressed surpriseregarding the disappearance of the HFRX Managed Futures Index inearly May 2004, which took place without any advance warning orexplanation on the weightings.

Secondly, the apparent higher heterogeneity of funds of funds ispartly due to the fact that mono-strategy funds of funds currentlyrepresent more than 54% of the fund-of-fund universe, and partly tothe fact that some multi-strategy funds have opted for a very activetactical allocation or use structural leverage. One should not mixheterogeneity and absence of a relevant classification. Moreover, as

seen above, heterogeneity between investable indices is higher thanthat between non-investable indices. Additionally, since investable



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indices feature short track records, there is a tendency to use eithernon-investable indices performance or simulated performance tomeasure the heterogeneity between investable indices, which resultsin underestimating it.

Thirdly, investable indices underperform the fund-of-hedge-fund

average when using non-simulated returns for comparison purposes.Indeed, having admitted that investable indices are funds of funds, itis clear that utilising extrapolated data prior to index launch would beequivalent to referring to a fund of funds’ simulated returns – anerror any sophisticated investor would be reluctant to commit. Suchpro-forma data either is the result of an optimisation process(whereby it always tends to be highly favourable) or has influencedhedge fund selection. Although all selectors are aware of the fact thatpast performance is no guarantee of future results, there remains anatural trend to privilege those hedge funds that have generatedattractive returns in the past. Therefore, it is not surprising that, asshown in Figure 2, all investable indices are poorer performers,immediately after their launch, than their non-investablecounterparts, whereas this is not the case for simulated periods.

Performance

4.9%

7.7%

4.3%

10.0%

20.9%

8.1%

0%

5%

10%

15%

20%

CSFB/Tremont Hedge

Fund

(Aug-03 to Jul-04)

HFR Hedge Fund

(Apr-03 to Jul-04)

MSCI Hedge Fund

(Jul-03 to Jul-04)

Non Investable Index

Investable Index

Figure 2

The table below compares the reported actual returns of theCSFB/Tremont, HFRX, MSCI and S&P investable indices with those of the EDHEC Funds of Funds Index1, which is found to outperform allinvestable indices for the various time periods corresponding to thereal track of each investable index.

1 The EDHEC Funds of Funds Index is the best estimator of fund-of-hedge-fundaverage performance. For investable indices, we use publicly-reported performancedata (such as Bloomberg) since the actual launch of each index to conduct

comparisons. Thus, these non-simulated figures do not incorporate tracking fees,management fees, entrance and redemption fees charged to investors, nor trackingerror-related differences.



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Performance Period

CSFB/ Tremont Investable Index 4.91% August 2003 -

EDHEC Fund of Funds Index 7.77% July 2004

HFRX Equally weighted Index 7.67% April 2003 -


MSCI Ivest Index 4.26% July 2003 -


S&P Hedge Fund Index 12.61% September 2002 -


Table 1

Finally, the liquidity offered by certain investable indices is unrealisticand infringes a cardinal risk management rule, whereby all hedgefunds must maintain a degree of adequacy between the actualliquidity of the portfolio and that offered to investors. As an example,let us assume that a manager needs several months to sell a portfolioof financial assets at fair market prices. If this manager offersmonthly liquidity to investors and that a large number of them

simultaneously request to sell out of the fund, he will be forced toliquidate assets at prices that will disadvantage stakeholders’ interests. Admittedly, investable indices are generally not invested infunds but in managed accounts providing holders with daily liquidity.Nevertheless, a managed account is in reality made up of a portfolioof securities where liquidity can be completely different to that of theaccount. Therefore, there is no true adequacy between the liquidity of investable indices and that of underlying managed-account positions.In other words, the exposure to liquidity risk is far greater than onemay tend to believe, and it is when investors will need it mosturgently that liquidity will most likely be refused them. This is thereason why certain index-linked investment vehicles offer attractive

liquidity but often charge dissuasive redemption fees within thepromised liquidity (using sometimes bid and ask spreads) or put inplace some aggregated redemption limits (redemption gates) so theycan differ redemptions.

NOTHING MORE THAN AN ILLUSION

In conclusion, investable indices are funds of funds in disguise: “Calling something an index does not make it an index” said ProfessorSchneeweiss in the April 2003 issue of “Absolute Return”. Indeed,investable indices expose their investors to hedge fund managerselection bias, to index management bias and sometimes to liquidity

risk. Reality shows that investable indices currently underperform thefund-of-hedge-fund average. Yet, since the majority of hedge fundsthat make up the fund-of-hedge-fund universe sometimes outperformthe average and that investable indices behave in a similar fashion,we can expect investable indices to occasionally outperform theaverage. Indeed, we can assume that the quality of the hedge fundselection performed to compose investable indices is in line with thatused to build up other funds of funds.

The illusion is to believe that investable indices are able to providesomething that other multi-strategy funds of funds cannot provide.

BibliographyDuc, F., 2004, Hedge fund Indices : status review and user guide Banque Syz & Co.



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3A S.A. – Alternative Asset Advisors Rue du Rhône 30

1204 Geneva SwitzerlandTel: +41 (0)22 819 9800

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