Using investable funds indices
Horizons have broadened for big investors, with many turning to the hedge fund market for the first time. But how, they ask, are they to tap into the absolute returns these vehicles promise without draining their resources? Index providers believe the answer may lie in investment products based on their new hedge fund indices.
The latest major player to offer an investable hedge fund index is FTSE. FTSE Hedge became available in April this year, a global index of 40 hedge funds, with a range of sub-indices covering the main strategies employed. The index has been designed to bring more clarity to the asset class. But as well as being an instrument to enable investors to observe the performance of hedge funds, FTSE is licensing fund managers to create funds based on the index.
The target audience for the FTSE Hedge is asset owners around the world, says FTSE’s Paul McLean. “Large numbers of asset owners are looking at the hedge asset class and they will want a consistently reliable index to measure what they’re doing,” he says.
Investable hedge fund indices are recent inventions, but already there are several providers offering the products. CSFB/Tremont, MSCI, HFR and Standard & Poor’s all have indices which perform a similar function. But as with most competing products, each has its own particular strengths.
“The S&P index is equally weighted by strategy,” says McLean. “We believe that to be a bit of a cop out.” What an investable index should be doing is trying to be truly representative of the underlying investment opportunities.
Some of the strategies that make up the hedge fund universe are more widely employed that others. For example, about 30% of all hedge funds available today, says McLean, are equity hedge. “So equal weighting distorts the representativeness of your hedge fund,” he says.
FTSE Hedge weights the investment strategies based on what the provider believes is the investment opportunity. “Obviously the underlying universe of hedge funds will change over time as some strategies are better than others,” he says. As an example, the merger market is booming at the moment, which boosts the values in merger arbitrage funds. “So our methodology is to revise those weightings in line with that.”
McLean also says that the FTSE index is more representative of the true geographical distribution of the hedge fund universe. Only 65% of funds are US, 30% Europe and five per cent Asia, he says.
Despite these criticisms, S&P says it is satisfied with its hedge fund index as a product. Based on the objectives the index’s creators set for themselves, they are very pleased to have achieved “a representative and investable index that satisfies the demands for improved transparency in hedge fund investing and to have been one of the first to do so,” says Peter Roffman, managing director of Standard & Poor’s Portfolio Service.
“We are also extremely satisfied with the market's reception of our index which we can measure by the assets (over $1.5bn) tracking it through various licensed products around the world,” he says.
Among the other investable indices now on offer, the S&P HFI has many points in its favour. “The methodology of our index,” says Roffman, “including equal weighting, broad, nine-strategy coverage, daily pricing, our inclusion criteria and the rigorous due diligence process we have instituted for screening and monitoring the funds, and unprecedented transparency in terms of the data we publish on our public website sets us apart from others in the space.”
At the moment, S&P does not expect to make any changes to the actual structure of the index. But it is designed to represent the investable opportunity set available to hedge fund investors, says Roffman. And as this market continues to grow and develop, the index will change to continue to reflect this universe.
The S&P Hedge Fund Index Committee monitors the composition of the index to make sure managers are still meeting the criteria for the index, he says. “Things like style purity, assets under management, and so on.”
Another reason why the index might change, he says, would be to add funds to accommodate the need for more investment capacity as the index tracker products continue to attract investment.
The main users of the index tracker products are institutions and rich individuals around the world, says Roffman. They are investors who want broad index exposure to hedge funds and desire or need the added transparency that the index delivers.
John Godden, managing director with HFR Europe in London, agrees with McLean that FTSE’s index is a smarter attempt to represent the hedge fund universe than the equally-weighted S&P benchmark. But he is doubtful about the choice of fund management firm the provider has chosen. “The difficulty is MSS, which is a new company, untried and untested,” he says.
He says both the CSFB/Tremont Investable Hedge Fund Index, launched in August 2003, and the MSCI Hedge Invest Index, which began in October, are good indices. But the edge that the HFRX has, he says, is that the firm behind it is such a specialist in the hedge fund arena. “We are hedge fund index providers,” says Godden. “That’s all we do.”
HFR (Hedge Fund Research), which has run its HFRI series of hedge fund indices since 1990, launched investable indices in the sector – HFRX – in April 2003. In the last four months, $1.3bn in new investments has gone into products tracking the index, says Godden. With $400m coming in each month, this is a very fast growing area.
“Twenty to 25% of all new investment into hedge funds is going into investable index products,” he says.
Even though some says hedge fund investment is about skill, and skill in picking those managers who have it, there are good reasons for investing via an index. There is beta to the alpha, he says. For example, with merger arbitrage, the good funds are very focussed in a narrow space, so you get tight clusters of the returns. You can buy an index product as a proxy for that strategy.
“Skill will enable you to buy better, but it (index investing) solves the problems of exposure to hedge funds.” They suit investors who want the exposure but can’t stomach the double-layer fees, the resource implications of due diligence and manager selection, he says.
“It’s a lot of the same theory that comes out of indexation in the traditional space,” he says. The mathematics, he says, tend to be on the side of those picking a median.
Although the index series includes several strategies – eight in the case of HFRX – as a first step, some investors do invest in products based on the overall index. “We’ve found our biggest users are funds of funds,” says Godden.
The umbrella vehicles use the index products as strategy overlays. They are also useful when making asset allocation changes. The funds can get very swift allocation while working out the fine details of longer-term holdings. “We’ve seen a lot of usage that way,” says Godden.
Some investors use the products to build up anti-correlation against long-only, by using strategy components of the index.
The HFRX can be used as an asset-weighted version, with the eight indices mixed together as in the universe. The components can be weighted however the investor wants.
Rather than having just one provider of investment products based on its indices, as is the case with some of the others, HFR provides tracker facilities to its partner banks. There are 13 of them, says Godden.