This month funds of funds provider HFR will announce the launch of eight style-based investable hedge fund indices, and the first swathe of index product licences based on them. HFR follows in the footsteps of S&P, which launched an index range last September, and ZCM, which has seems already to have come and already been and gone in the investable index business, consolidating the idea of an asset allocation approach to hedge fund investing for retail and institutional investors.
In certain regimes, notably Germany, the advent of hedge fund indices on which to structure investment products will bring huge tax advantages over existing FOF-based structures, and relief from regulatory pressure for those currently distributing products on questionable ‘indices’. But in general, in the short term, most activity will be undertaken on behalf of institutions seeking either strategic or tactical asset allocation to hedge fund strategies, and private banking, broadly the same market as for existing capital-protected hedge fund business.
Indices have inherent advantages over fund of funds for institutional investors, however. As Mehraj Mattoo, head of structured products at Dresdner Kleinwort Wasserstein puts it: “They like the diversification of hedge funds, which so far in Europe they have accessed through funds of funds, but they don’t believe the fees are justified, and in any case they would rather buy an index, because it has better liquidity.” Initially, costs will vary by index provider, but for an HFR product will be 0.60-0.75% per annum, including the bank’s own fee, according to Mattoo. S&P products are currently more expensive, since the house imposes its own fee of 1% for replicating the index.
Jean-Marc Spitalier, head of funds structured products at Lehman Brothers, says the figures look even better when you bring in the cost of capital protection, which on a fund of funds is something like 100bps on top of fees. “For roughly two thirds of an institutional fee, you can get exposure to a broadly-diversified basket of hedge funds tracking the 2,000 consitutents of the HFR index, and capital protection,” he says.
So long as there is no performance cost to this route, index products should be a no-brainer for institutions. Spitalier says: “Obviously it depends if you are a great believer in the ability of fund of funds to overperfom an hedge-fund index, but there should be some natural over performance delivered through the HFR index because their safe managed account platform means they can take out most of the hedge-fund risk (ie fraud and style drift) and carry out on-going due diligence. In a way they also do the job of a fund of fund.”
Investable indices are designed not to outperform the broad index, but to track them, and to express the returns of each style. There are two components to hedge fund returns – the performance ‘inherent’ in a style, and the skill of the manager. Much research has been done in this area. While some styles contain a higher proportion of ‘inherent’ return than others, it is not hard to draw the conclusion that it is easier for an investor to add value to a portfolio through style selection than by trying to pick superior managers.

Be that as it may, other commentators would argue that there is little point in having access to mediocrity (or to blow-ups) if you can avoid it. If the index providers really do the job of a fund of funds, any tracking error ought to be found north of the index, “and nobody minds that,” laughs Spitalier. This is where the research-driven fund of funds houses come in. They argue that they are best placed to develop indices on hedge fund styles because they can deliver both inherent returns by closely tracking the broader index and through a scrupulous research and due dilligence process can avoid fund blow-ups.
With some styles, particularly global macro, such replication is a tall order, since many of the top-performing managers are so closed they are managing money only for themselves and a handful of investors, leading some observers to question whether they ought still to be categorised as funds. Even here, however, things are changing. Global macro’s renaissance of the past couple of years has brought in new managers who are giving the return of the overall category.
The case might be made for indices in general, but which index? The two main contenders for the index crown are the S&P, because it has the brand, and HFR, because it has a strong reputation for research. While the ratings agencies are very new to hedge fund due diligence, the importance of the S&P brand should not be underestimated, particularly for retail products. S&P’s index components are picked by PlusFunds, a new entity made up of industry veterans.
But it is HFR that seems to be the early industry favourite for an institutional audience. The house is well known for its excellent research and due diligence process. “The real difference,” says Spitaler, “is that HFR has the ability to track a fully-representative index.” It already publishes a hedge fund index, comprising 2,000 hedge funds, and because of this it is well placed to track the style components and the overall index with its investable series, he says. Spitalier has been ‘working closely’ with the research house, and hopes to be both one of the first licensees and market makers to the index. Liquidity for the HFR indices will be provided by a market maker system.
Both indices use managed account platforms, and therefore have – technically at least – relatively good liquidity. S&P has around 40 managers and HFR a platform of 113 managers, though how many of them appear in the indices has not yet been disclosed.
Mattoo says of the respective index providers, “HFR’s platform is based on excellent research and due diligence. It remains to be seen how much due diligence S&P are able to bring.” He also believes that the HFR index is likely to outperform, saying, “Here we have indices that should also add alpha.”
Assuming a conservative $50m per managed account, HFR and S&P ought to be able to support at least $5bn of index product between them – more than enough to be going on with, says Spitalier. The bulk of this will be in index-linked bonds, structured much like inflation bonds, with a minimum coupon and a partial index link. “After that, we can provide any sort of derivative on the broad index,” says Spitalier. Guaranteed products based on some styles are likely to be relatively expensive, though, he warns: “Hedge fund volatilty does not express tail risk, particularly in low volatility spread-based strategies.” Mattoo adds that instead, we are likely to see such developments as lock-in structures on the composite index, using cliquet options, which protect gains in the index.
A more likely use of the sub-indices will be to fine tune asset allocations in accordance with correlation requirements or investment guidelines. Spitalier says Lehman is, for example, planning to offer customised versions of the indices. A fund wanting zero equity correlation, for example, might take out global macromerger arbitrage and long short strategies. Another fund might not be permitted short “non ethic” investments, and so all managers with shorts in their guidelineslong stocks with ‘non ethic behaviour’ can be removed.
The more sophisticated hedge fund investor has a fantastic tool box to play with. Assuming a secondary market develops, he will be able to buy and sell the style indices, using them to ‘equitise’ cash, or to liquidate positions in the underlying. If he wants to reduce a position in an underlying manager slowly, he can sell the index first. Or he could implement a tactical asset allocation programme based on an economic view. Or he could take a view on the likely short term performance of a particular manager and structure and structure a cfd, or sell the index against the position.

Topics