Alpha bets

Index investing has rolled over active managers in the mutual fund world. Hedge funds may prove a more elusive prey.

Index investing has rolled over active managers in the mutual fund world. Hedge funds may prove a more elusive prey.

By Hal Lux
August 2002
Institutional Investor Magazine

Theoretically, if any asset class should benefit from the spartan values of the index investing revolution, it ought to be hedge funds.

Consider their many vices.

Fees are exorbitant. The risk of catastrophic losses for individual funds is real. And investors can’t count on hedge fund managers sticking around for long, be they colossal successes or massive failures. All of these factors make the idea of a low-cost, highly diversified hedge fund index sound like a tantalizing alternative to trying to pick the next hedge fund star.

“Conceptually,” says Leslie Rahl, president of risk management firm Capital Market Risk Advisors, “the idea is appealing.”

Hedge fund index products, however, have been very slow to take off. In the past decade the hedge fund industry has grown from 2,000 funds with $67 billion under management to 6,000 funds with $600 billion under management, according to hedge fund consulting firm Van Hedge Fund Advisors International. And funds-of-hedge-funds -- the actively managed equivalents of hedge fund indexes -- have grown at an even faster clip, from $400 million in 1987 to $115 billion in 2002, according to investment management consulting firm Casey, Quirk & Acito.

But despite efforts by such powerhouses as Credit Suisse First Boston, Deutsche Bank and Zurich Capital Markets to promote hedge fund index products, the amount of money invested in hedge fund indexes is thought to be no more than a couple of billion dollars. The lure of index funds is that they can provide better, more consistent returns than an actively selected portfolio of the “best” managers within different strategies. That is well-nigh heretical in the world of hedge funds, which thrives on promoting and selling genius.

“We are swimming upstream,” says Timothy Rudderow, president of Princeton, New Jerseybased Mount Lucas Management Corp., which has signed up just one institutional investor in 12 months for its MLM Global Markets Strategy, a synthetic index that tracks the hedge fund market. “We are telling investors something they don’t want to hear.”

But a new push is about to get under way, one that may once and for all test the potential for index investing in the hedge fund world. Standard & Poor’s, the brand name in investable indexes for traditional money management, is readying a 40-fund hedge fund index designed to function as a practical investment vehicle for institutional investors. And Morgan Stanley Capital International, another marquee name in the index business, has just released its own hedge fund indexes, which will initially serve as performance measures but could eventually give rise to investable products.

S&P’s main index and specific-strategy sector indexes will be direct competition, not for hedge fund managers, but for fund-of-hedge-funds managers, who charge hefty fees for assembling portfolios of hedge funds. S&P has licensed the indexes to hedge fund investment shop PlusFunds, which will market them as investments to institutions. If fund-of-funds managers, after subtracting their typical cut of 1 percent of assets and 10 percent of profits (on top of hedge funds’ take), are not able to beat these low-cost indexes, they -- just like active mutual fund managers who don’t beat stock indexes -- will increasingly appear worthless to investors.

What has happened to the mutual fund industry should give fund-of-hedge-funds managers pause. For the past 20 years, only 16 percent of surviving actively managed U.S. mutual funds have beaten the cumulative returns of the Standard & Poor’s 500 index, according to mutual fund data company Lipper. That sorry record has made passive investing the ascendent philosophy of mainstream stock market investors.

“That’s exactly one of the arguments we’re making,” says Paul Aaronson, Standard & Poor’s executive managing director in charge of the hedge fund product. “Why would a fund-of-funds manager trying to pick hedge funds be any better than an active manager in picking stocks?” Mount Lucas chairman Frank Vannerson, one of the founders of legendary hedge fund shop Commodities Corp., says he is equally certain that the average fund-of-hedge-funds stands no chance against his low-fee index. Says Vannerson, “We will beat them by the amount of their fees.”

Fortunately for the alternative investment industry, the type of indexing that has thrived in stock mutual funds is not easily duplicated in hedge funds. For starters, mutual fund indexes invest in securities; hedge fund indexes invest in people who invest in securities. Indexing a group of managers is obviously a lot more difficult than indexing a portfolio of stocks.

Further, securities owned by stock and bond mutual fund indexes are liquid and typically traded in public markets. Hedge funds tend to be illiquid and anything but transparent; the exact size of the overall market is unknown, performance reporting is done at the whim of fund managers, and many of the most successful hedge funds are closed to new investors. Even some of the people attempting to construct indexes around hedge funds express caution about what they’ll be able to deliver.

“There are many peculiarities in terms of constructing hedge fund indexes,” acknowledges Khalid Ghayur, global head of research with MSCI. “We do not feel comfortable calling them benchmark indexes as we do our stock and bond indexes. However, they can serve as a meaningful basis for conducting peer group comparison and analysis, and we believe they will be valuable to the investment community.”

Some wonder why anyone would bother building a hedge fund index in the first place. In a paper soon to be published in the Journal of Portfolio Management, Carlyle Asset Management Group alternative investment expert Jimmy Liew argues that investors should stick with actively managed funds-of-hedge-funds because the performance of an average hedge fund manager -- which is exactly what an index should provide -- does not appear to add value to an overall investment portfolio. “At first glance indexing appears to be a cheap, low-risk strategy to get exposure to hedge funds,” writes Liew, who has a Ph.D. in economics from Columbia University. “A more careful analysis, however, argues to the contrary. In our sample only 30 percent of the managers demonstrate statistically significant skill. A corollary to this result is that a hedge fund index that includes a large fraction of unskilled managers will be significantly inferior to a portfolio of actively picked ‘good’ hedge funds.”

Even the lord high king of indexing -- Vanguard Group founder Jack Bogle -- can’t come up with a kind word to say about investable hedge fund indexes. “I don’t see how you can do indexes with hedge funds,” grumbles Bogle, who goes on to dismiss all hedge fund investing as “the next great debacle.”

Index products, however, have surprised the money management world before. Vanguard’s first index mutual fund, launched in 1976, was dubbed “Bogle’s folly” when it first appeared. Today Vanguard runs $210 billion in stock index funds. History is not likely to repeat itself to that extent in the hedge fund world because of the complexity of running large amounts of money in indexes tracking that market. But these index funds could certainly become a profitable niche market, especially given the high probability that they will end up beating the average high-priced fund-of-hedge-funds manager over time. In any case, these indexing projects should at the very least provide badly needed competition to a fund-of-funds business that has had it much too easy in recent years.

“We do represent a threat to some funds-of-hedge-funds,” says S&P’s Aaronson. “They charge an additional fee on top of hedge fund fees -- that’s an expensive proposition for investors.”

ADAPTING INDEX INVESTING TO HEDGE FUNDS is anything but simple. To begin with, what exactly is to be indexed? Little information is available about the distribution of assets among different hedge fund strategies, and that forces index makers to essentially guess what index would mirror the performance of the universe of hedge funds.

Even if the existence of a hedge fund is known, there’s no guarantee that its performance numbers can be secured. MSCI’s index will be based on returns from 350 funds divided into four broad strategies: directional, relative value, specialist credit and stock selection. But those funds may opt out of the index anytime they want.

Zurich Capital Markets has produced an equal-weighted index of 58 funds, which are added or deleted by a selection committee. The CSFB/Tremont hedge fund index uses mathematical formulas to select its asset-weighted group of 385 funds. Deutsche Bank has 100 funds equal-weighted in its DB-100 Benchmark Fund, while S&P has decided it needs only 40 funds to reflect the entire industry.

Not surprisingly, the indexes can sometimes diverge significantly. For example, in 2001 Zurich Capital Markets’ hedged equity index fell 12.2 percent; the CSFB/Tremont hedge equity index fell 3.7 percent, and an index run by Chicago-based alternative investment specialist Hedge Fund Research rose 0.5 percent.

Constructing representative indexes that are investable certainly requires compromise. Standard & Poor’s can put any stock or bond it chooses into its traditional indexes. But the company is much more restricted in creating its hedge fund index, because the product wouldn’t have any practical value as an investment vehicle if investors couldn’t get into the funds. As a result, S&P has only included in its index hedge funds that have agreed to make at least $100 million in capacity available to investors in these products.

In addition, hedge fund managers must agree to provide daily information about their positions and pricing to S&P. That level of transparency is unheard of in the traditional hedge fund world, prompting some hedge fund experts to speculate that only new managers or those desperate for additional assets will go along with these conditions in the middle of a hedge fund investment mania.

“I would rather spend six months trying to get the right investor at this point than take this money,” says the marketing executive of one large fund. “You’re going to get a lot of managers that have been doing badly, you’re going to get adverse selection.”

Standard & Poor’s has not yet announced the names of the funds in its index, but several hedge fund executives say they know of some prominent hedge funds that turned down the company.

S&P’s Aaronson concedes that attracting underperforming managers could be an issue. “We were concerned about that ourselves,” he says. “Is there some negative selection bias?” Aaronson insists, however, that S&P has managed to sign up a roster of high-quality managers.

But deciding what constitutes a good manager for an index product can also be tricky. The first goal for any index is giving investors very specific exposure to a well-defined asset class. S&P, which selected managers with the help of British hedge fund consulting group Albourne Partners, explains that style purity -- a manager’s rigorous adherence to a specific trading style -- is more important than even returns. Bad performance probably won’t get an investor thrown out of this index, but style drift will. “Funds-of-funds are looking to pick the best-performing managers,” says Aaronson. “We’re looking to pick the most representative.”

Some investment experts believe, however, that dividing managers into traditional hedge fund categories can be misleading. S&P has selected managers from nine traditional categories of hedge fund investment -- including long-short equity, merger arbitrage and convertible arbitrage -- to come up with what it hopes is a good representation of total hedge fund activity. But some analysts say these traditional categories don’t accurately reflect the hedge fund world’s strategies and risk. “There is a need to redefine these categories,” says Capital Market Risk Advisors’ Rahl. “The hedge funds, for example, within convertible arbitrage are dramatically different. You should have a long-volatility strategy category, an equity-directional strategy category.”

Although hedge fund indexes have been a tough sell, S&P faces an equally perplexing problem if they become a smash hit. If the funds won’t take on more than they’ve promised S&P from investors buying indexed investments, the index could end up being a revolving door as high-performing managers leave quickly. “S&P has got to be kidding about the $100 million,” says Philadelphia-based quantitative money manager Theodore Aronson. “In this kind of market, that could get sucked up in a matter of days.”

The pros at Mount Lucas believe that the downside of using traditional indexing in hedge funds is problematic enough to require a different approach. Last year the quantitative shop, which has for the past decade run a successful passive investment product for managed futures, rolled out an index-style product that attempts to mimic the returns of hedge funds without actually investing in any. “Hedge funds operate in this very diverse basket of marketplaces,” says Mount Lucas president Rudderow. “We think we can measure the risk premium in different markets.”

Hedge funds say they earn the bulk of their returns utilizing nimble and idiosyncratic trading strategies. Mount Lucas believes that over the long run the performance of most hedge funds simply mirrors the overall returns of the markets they specialize in and that no particular skill is involved. For example, Rudderow argues, managers in the much celebrated convertible bond arbitrage sector really just hold long portfolios of stocks. Last year Mount Lucas launched MLM Global Markets Strategy, which, like hedge funds, gives investors exposure to a broad array of markets by buying futures contracts in stocks, bonds and commodities. And the fees are as low as 50 basis points of assets, compared with 1 percent of assets and 10 percent of profits for funds-of-funds.

Ultimately, the theoretical debate about how to best build a hedge fund index will give way to a simple performance race between the indexes and hedge fund managers. If fund-of-funds managers are unable to surpass low-cost indexes in picking hedge fund talent, investors will flock to the variety of passive products, and the high fees associated with hedge fund investing may finally fall.

The outcome remains uncertain. But the always rational indexing crowd -- which has already seized big chunks of the traditional money management market -- is confident that a growing group of hedge fund investors will someday choose the rational efficiency of indexing over seductive manager pitches. “People want to believe in the magic,” says Mount Lucas chairman Vannerson. “But since we started managing money, we’ve offered people diversification, not a free lunch.”