Hot on their tracks

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Plunging stock prices over the past year have sent investors scouring the markets for alternative investments. In theory, hedge funds can be a sanctuary. Some strategies, at least, have got away with moderate falls when the broad equities markets are sinking fast.
Pension funds are attracted to hedge funds as diversification away from bonds and equities, says John Godden, managing director of HFR (Hedge Fund Research) Europe. “They want the volatility benefit you get from a hedge fund,” he says.
But for a pension fund, investing directly in a hedge fund can be impossible, due to regulation. And even if this were not the case, there are other deterrents. Fees for hedge funds can be extremely high; the risk of huge losses within any one fund can be high; success depends crucially on individual managers who may jump ship and liquidity in these funds can be very restricted.
“High-net-worth individuals and institutional investors are increasingly looking to achieve diversification in returns and risk from their traditional investments of cash, bonds and equities through investing in hedge funds,” says Tushar Patel, an investment manager at Global Investment Advisors in
Investment in hedge funds has grown from $20bn (e20.4bn) in 1990 to more than $550bn, he says, with an estimated 30% allocated by institutions and 70% by high-net-worth individuals, compared to 1990, when an estimated 90% had been invested by the latter.
High-net-worth individuals and institutions in Europe may not have the skills or investment managers and analysts to identify, assess, invest, track and undertake due diligence of hedge funds. “There are estimated to be 6,000 hedge funds globally. How do you invest in a particular fund? Unless you have the teams in place to carry out the assessment, it is a difficult process,” says Patel.
These hurdles combined with the current trend towards passive investment have been behind attempts to create investments that track hedge fund indices. Although there is already a huge industry in offering funds of hedge funds, the vehicles inevitably involve some degree of double pricing. Also, while they spread the risk of manager selection, they do not eliminate it.
The attractions of hedge fund trackers are clear, but in practice the whole area of hedge fund indices and any investment seeking to replicate or track them is fraught with difficulties.
Only a handful of hedge fund indices are available, although major index player Standard & Poor’s is set to enter the arena soon.
The CSFB/Tremont Hedge Fund Index comprises 334 hedge funds, and is constructed using a database of more than 2,600 funds. For a fund to qualify for inclusion, it has to have at least $10m under management and an audited financial statement.
This index has nine style-driven sub-indices. Values are calculated monthly.
In March 2001, Zurich Capital Markets launched a series of global hedge fund indices, tracking the performance of five different hedge fund strategies – convertible arbitrage, merger arbitrage, distressed securities, event-driven and hedged equity.
Earlier this year, S&P said it planned to fill a gap in the hedge fund market by offering a transparent hedge fund index. Calculated daily, it will contain 40 funds, and these will be divided up into three sub-indices – arbitrage, event-driven and tactical. These three sub-indices will, in turn, represent a total of nine specific strategies.
S&P has given PlusFunds – a developer of passive hedge fund investment products – an exclusive licence to develop certain investment products on the index.
One of the major problems encountered in attempting to put together any index of hedge funds is the huge variety of different types of fund that are on offer, says Godden. “The disparity you can get between a basket of hedge funds is enormous,” he says.
By investing in an instrument that replicates an index representing a broad spread of hedge funds, the risk of choosing the wrong manager should in theory be reduced.
“The idea is that you get rid of all the abnormalities,” says Godden. “What investors want is something similar to a FTSE tracker, rather than getting an active manager, and that is being transposed into hedge funds.
“That’s the theory and the practicality is worlds apart from that, unfortunately,” he says.
Global Investment Advisors markets a multi-strategy tracker fund of hedge funds – GAIM Hedge Fund – which was launched last August. Assets are invested in the largest investable funds, measured by asset size, in the CSFB-Tremont Hedge Fund Index.
Assets are allocated to the five largest investable funds in each of the four main strategies – macro, market-neutral, long–short equity and event-driven. Although the fund is called a tracker, Patel explains that mirroring the returns of the index is not the fund’s objective. The aim is to give exposure, he says.
Some 40–50% of hedge funds are closed to new money, he says. But he adds that it is precisely because popular hedge funds are closed to new investors that funds of funds which effectively follow an index are used. This, he says, is a way of accessing these closed funds.
A fund of hedge funds has a relationship with the hedge fund managers and they will allow them to make discretionary new investments, says Patel. “We give access to these funds,” he says.
When Zurich Capital Markets launched its hedge fund indices, it coupled this launch with the introduction of a series of investable benchmark portfolios – the Zurich Institutional Benchmark Series. These would be investment products that tracked the returns associated with the Zurich Hedge Fund Index.
Although the ‘benchmarks’ would be portfolios constructed to track the indices, they would not attempt to replicate the indices. Acknowledging that the indices may include a number of hedge funds that could not or would not offer managed funds, Zurich said it was not possible to construct a ‘benchmark’ simply by replicating the composition of one of the hedge fund indices.
Godden says every one of the hedge fund indices in existence is heavily flawed. “We’re not confident enough to have tradeable versions of an index yet. All they are is funds of funds – they’re just somebody’s version of an index.”
All the monthly feeds of data on a hedge fund are based on valuations by the manager, and there is no way of checking that the information is accurate, says Godden. HFR Asset Management does not offer funds that claim to track hedge fund indices, but instead enables investors to gain exposure to hedge funds via funds of funds, single manager funds and customised multi-manager funds.
“If people are looking to take away the fund of funds manager-specific risk, forward risk and style alteration, the ones out there don’t do it,” says Godden.
The solution, he says, to creating an index that really is investable is to have an index which fully represents the universe. But among hedge funds, because there are so many strategies covered, in many cases, the indices use only a small number of funds to represent that sector of the hedge fund market. “How can one manager be representative of, for example, merger arbitrage?”
HFR has done cluster analysis to see how many funds there are which correlate to the individual substrategies. The research has shown that more than five funds per substrategy are needed. “To get somewhere near that in reality you need between 200 and 250 funds to represent the universe,” says Godden. “You’re dealing with something that has 4,000 alternatives; somehow you’ve got to take out all of these variables before you can get an index.”
Patel agrees that the complexity of hedge funds makes them difficult to track.
Godden says there is a market for hedge fund trackers as long as people are content to have an investment that does not fully represent the hedge fund universe.
He sees a problem in S&P launching a hedge fund index, because the index provider has a reputation for creating indices based on things that are definable. “For them to bring that to something that’s not definable is potentially misleading,” Godden says.
However, S&P has said that funds considered for inclusion in its indices will have to pass a series of quantitative screening criteria to make sure they conform to the stated return and risk characteristics for their strategy. On top of this, eligible funds will have to agree to offer daily transparency so that their valuations can be verified by a third party.
Patel says the perception that hedge funds are risky is not accurate, associated with some macro funds. The macro funds, which attract a lot of attention, make up for less than 13% of funds under management within hedge fund universe, he says. And the slump and volatility in equity prices over the last year has enabled some hedge fund strategies to shine.
“Even the long–shorts, which are highly correlated with the equities market are only down 1 or 2% this year, compared with the FTSE which has fallen around 25% in local currency,” says Patel.

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