The search for absolute returns has fired investor interest in hedge funds. Clarity, however, is a rare commodity in this sector of the investment fund universe. So index providers have been quick in their efforts to cater for information-hungry would-be hedge fund investors.
In mid 2002, two index giants – Standard & Poor’s and MSCI – developed and launched their own hedge fund indices. Both providers have sought to take the mystery out of hedge funds by setting up clear and transparent benchmarks to track the sector. Beyond this, however, the aims of the two US rivals have been quite different.
From the outset, S&P set its sights on creating an investible index – one that could be tracked by an investment vehicle, allowing investors to get direct exposure to a diversified hedge fund vehicle. MSCI’s priority, on the other hand, was to make an index that was as comprehensive as possible, and could be used primarily as an analytical tool.
“They are built for different purposes,” says Peter Roffman, vice president at S&P. “Our index is daily, and that’s the most overriding and easily discernible difference. Most funds report their NAVs on a monthly basis. So the way we did this was to get them to set up managed accounts that are run in parallel to the fund, with daily NAV transparency.”
Values of the MSCI Hedge Fund Indices are calculated monthly. “It’s very much a tool to understand what hedge funds are doing,” says Michel Serieyssol, global head of Hedge Fund Index Business at MSCI. “What you have is a whole database of 1,700 funds. It creates a lot more granularity and detail… you’re able to see similar funds together and that creates a great deal of usefulness for the investor,” he says.
The MSCI database can be cut in several ways to facilitate different types of analysis. There are 150 indices within the index family, says Serieyssol. The indices are constructed with four levels of aggregation – strategy, investment process, process group and composite. At all four levels of aggregation the indices are equal weighted and asset weighted at the two highest levels of aggregation – composite and process group. In addition to all of this, there are three domicile families – onshore, offshore and all domicile.
The S&P Hedge Fund Index contains just 40 funds, and these are divided into three sub-indices. The sub-indices are arbitrage, event driven and tactical. In turn, these represent nine specific strategies including macro, equity long/short, managed futures, special situations, merger arbitrage, distressed, fixed income arbitrage, convertible arbitrage and equity market neutral.
Even though S&P’s index covers far fewer funds than the MSCI, the creators are still confident from their research that the index is representative of the hedge fund world. “As you apply 35 to 40 funds, the range of risk/return produces tighter and tighter bonds. Then you get to 41 and it doesn’t help the representativeness – a 50-fund index isn’t any more representative than a 40-fund index.”
In creating its index, S&P has had to balance investability and representation. Investability, says Roffman, is tricky in the hedge fund world because of the levels of due diligence which are necessary. Funds in the index have to pass a rigorous due diligence process conducted by hedge fund consultant Albourne Partners, to make sure they are appropriately managed, stick to their stated strategy and maintain risk controls and operational infrastructure.
“By having a daily index you can see how the index is reacting to market events on a daily basis. You wouldn’t have as vivid a comparison if you had to wait until the end of the month,” says Roffman.
PlusFunds, a developer of passive hedge fund investment products and a service provider for the hedge fund industry, has designed a tracker fund to create exposure to the index. By doing the due diligence, S&P has created an institutional quality product, says Roffman, adding that other providers are not necessarily interested in that.
The quality and size of the funds to be included in the index is crucial, he says. “We don’t want a fund with $10m (E10m) under management… we’d worry about the business quality of such a fund. We want funds that are going to survive and whose track record is reflective of what it can do.”
Users of the MSCI index include hedge funds themselves and pension funds, foundations and endowments, says Serieyssol. “People who want to invest or better understand hedge funds, or those who are currently invested and want to compare one hedge fund manager to another,” he says.
A lot of work has gone into the MSCI hedge fund classification system, he says. “You’re able to see things you couldn’t see before,” he says. “Hedge fund managers have to define themselves according to what we have defined as classifications.”