As hedge funds hold a diverse portfolio of different assets, comparing their performance against traditional market indices is always going to be an imperfect science. Credit Suisse Index Company, in a report titled The Hedge Fund Industry Rocks Both Bear and Bull Markets, reiterates the danger of comparing hedge funds with traditional indices that represent only a single asset class.
“Hedge funds maintain exposure to a range of asset classes so a comparison to a traditional market index that represents a single asset class is misleading,” says Christian Hoffman at Credit Suisse. “The starting point in constructing a hedge fund index is that there is no exchange to pull the data from, so there will always be some level of skew.”
But hedge fund indices are not a perfect solution either, for a raft of well-documented reasons such as survivor bias, self-classification and style drift, as fund strategy will morph quickly when new opportunities emerge. According to a paper issued by Barclays Capital last year, imperfections in the way hedge fund indices are compiled flatters their returns by 1 to 6 percentage points per year, depending on the index.
Born survivors
“Some indices suffer from survivorship bias because if a fund is shut down or dropped its entire historical performance is deleted from the index,” says Mr Hoffman. “We ensure any liquidated fund’s historical performance is kept in, just as Enron’s historical performance stays in the Dow. But some funds are just not willing to provide the data – they may have had a blip, for instance, and this will be hard to reflect.”
Other indices are based on managed accounts where the underlying managers provide full transparency of their holdings, with each and every trade viewable by the index provider, which in turn allows for better monitoring of style drift and risk measurement. Large, successful operations usually feel no compunction to take part, however.
According to one prime broker manager who declined to be named, an investable index will trail anywhere between 200-450 basis points behind a broad hedge fund index, depending on which research is looked at, demonstrating the impact of stripping out the best managers. Following that logic, of course, it is more effective to hire a fund of funds at around 75-100 basis points.
While all hedge fund indices will be skewed to funds that are looking for capital and doing well, even those that do report tend to wait for a period of strong performance before publishing their figures. Then, when they enter the index, this strong run is backdated into its past performance data.
Classification is an enormous issue owing to the diversity of the universe. Ken Heinz, president of Chicago-based index compiler Hedge Fund Research, says that the firm constantly monitors for emerging sub-strategies.
Adapting industry
“This industry is dynamic and quickly develops strategies to focus on opportunities as they arise,” he says. “Take volatility trading strategies. A fair number have come to market in the last few years, but previously they were not a distinct group and were rather scattered around. Another example might be hedge funds investing in stocks that are engaging in shareholder activist techniques – a subset of the event set. We’re currently making an effort to identify and construct a universe for them. The trend is very much towards more specific benchmarks which work down to more granular areas.”
Hedge fund managers usually select their own classifications, although the index compiler may have something to say about this, and some indices give each fund an identical weighting – no matter its size – which also distorts what is happening in practice.
“One issue is whether a certain hedge fund is being categorised as, say, ‘convertible arbitrage’ on an historical basis, or by looking at current assets,” says Adam Sussman, senior analyst at research and advisory firm, TABB Group. “Is it a voluntary classification that the hedge fund gave itself, in which case it may not mean anything. Take ‘multi-strategy’ – now could anything be more ambiguous?”
Asking managers to self categorise may mean asking them to identify themselves as either a hero or a dog. Placing hedge funds into buckets according to their return histories makes it easier to identify returns attributed to manager skill and returns attributed to style benchmarks. Using actual peer-group benchmarks within each grouping also captures any non-linearity inherent in each strategy.
Adding transparency
A lot depends on the sector. “Indices provide a guide for people who are beauty parading. They distil a category, and that adds a level of transparency,” says Melanie Hill, managing principal at quant specialist Sabre Fund Management. “Multi-asset is a broad remit, for example, but if you look at EuroHedge, for instance, then the category is quite carefully split down. Our fund is quant equity market neutral, so we feel it is pretty relevant - not absolutely precise but all the funds in the category are following algorithms, usually in the equity region. Only one or two funds of the 42 are not doing what we’re doing,” adds Ms Hill.
The beta of many hedge funds can also be difficult to determine, clouding how much of the headline performance figure is down to manager skill. Actual performance may not be a result of excellent stock-picking or skills in an asset class, but beta from the whole asset class in question. In terms of assessing skill and value for fees, bald figures may therefore flatter because they take no account of the underlying market beta.
In practice, the HFRI Composite Index has underperformed the S&P500 and the FTSE All-Share in three of the past four years. More broadly, last year the HFRI index rose 12.88 in the year to January 2007, compared with 18 per cent for the MSCI. Over three years, it rose an average of 10.5 per cent per annum to January 2007, compared with 12.7 per cent per annum for the MSCI.
This is exactly as one would expect. Hedge fund investors should arguably be concerned if they beat the markets in years where equity returns are reasonably good, as such a pattern would suggest that the hedge fund has become a geared long-only fund and will not provide any protection in a correction.
Like for like
“You can’t compare hedge fund indices to broader equity indices as they have different goals and different strategies,” says Mr Sussman. “I talk to pension funds a lot about benchmarking hedge funds, and none of them use a hedge fund index to examine their performance. Instead they tend to use Libor plus, because they want to assess performance over and above the risk-free rate. The reason most are using hedge funds is to diversify their portfolios away from equities. They already have swathes of investments highly correlated to the equity benchmark – that’s part of the reason they chose hedge funds.”
As “most hedge fund indices contain closed funds that are non-investable, there isn’t much point comparing most indices of hedge fund returns against equity indices, as you can achieve the performance of the equity index, but you can’t achieve the performance of the hedge index,” adds Gareth Parker, Business Unit Head – Alternatives at FTSE Group.
THE NEED FOR BEST IDEAS IN AN INCREASINGLY CROWDED SPACE:
The HFRI Composite index of hedge funds has risen at an average annual rate of 8.4 percent since 2000, around half the rate of the 1990s. Not surprisingly, long-standing hedge fund investors hark back to the early days of the industry when funds were small and pockets of inefficiency were numerous and relatively easy to find and exploit.
“We have certainly seen increased investor appetite for higher conviction, ‘best ideas’ funds,” says Anita Nemes, managing director of Merrill Lynch, Global Markets Financing and Services. “As the successful examples have shown, these funds do exhibit higher volatility (and higher return) profiles for which there’s definitely more demand in a low volatility environment.”
“Best ideas funds are an attempt to stand out in a crowded, mediocre field,” says Aaron Schindler of managed futures hedge fund manager, Schindler Trading in Hartland, Wisconsin. “There are many funds in some strategy areas and that is probably diluting returns in those areas. Best ideas funds give the manager the freedom to move around the world and across markets to take advantage of pricing dislocations and bubbles and crises whenever and wherever they occur.”
But best ideas funds have drawn criticism as they are often structured as side-pockets or offshoots of an existing account set up to gain additional exposure to a handful of top positions, and debate centres on whether this can dampen returns for the flagship fund, as well as create potential conflicts of interest.
Standard Asset Management (SAM), the high yield and emerging market bond arm of the South African bank, is to launch its first hedge fund in a best ideas format. The Emerging Markets Opportunities Bond fund will be a leveraged, concentrated product targeting annual returns of 10-13 per cent after fees and volatility of less than 5 per cent.
Kevin Colglazier, chief investment officer at SAM, says that as a small boutique, the fund’s positions will be too small to cannibalise any returns under its management elsewhere. “We’ll be using trades we use in other funds and we will leverage it up a bit. But we run $1.3bn, so there is no issue of cannibalising returns on other funds. For the large managers, whether long-only or hedge funds, the bigger they are the more of a problem this could be.”
The demand for ‘best-ideas’ funds is already allowing some hedge fund managers to hike their fees to 2 per cent (annual management fee) plus 25 per cent (incentive
fee) even though their running costs are lower.
But the concept is new. While a crop of funds are in the throes of launching, from managers such as Oceanwood Capital, Gandhara Capital, set up by Deutsche Bank alumni Davide Erro, and Silverstone Capital, which is launching its Monza fund this month, Landmark Select, a portfolio of the best ideas of independent value managers, has been around for nearly four years.
Last month’s launch of Optima Fund Management’s fund of ‘best-ideas’ hedge fund also demonstrates that the concept has already come of age.
