An Index Is Not An Index Is Not An…

All hedge fund indices are not created equal – which is something many investors are probably not aware of – and it’s going to get even fuzzier real soon. John Prestbo of MarketWatch reports that loads of money have flowed into hedge funds on the strength of the performance by hedge funds in various strategies, but often the funds that produced the best results are already closed to investors, so the investable index includes those still open, and whose results may be less than stellar. In addition, says Prestbo, the number of components of the different indices vary wildly, and that could distort the true picture of the industry. For example, the Dow Jones Hedge Fund Strategy Benchmarks has just 45 component funds while the MSCI Hedge Invest Indices have more than four times that number. But there is a new breed of index on the horizon that may be hedge funds in name only because they cut out the middle man – the active manager, whose acumen is usually credited for those great returns investors clamor for. The new creations come in two varieties. The first, according to Prestbo, citing a Merrill Lynch corporate report, intends to produce hedge-like returns by “mechanically mimicking” what HFs do by “using liquid investments such as equity, bonds, currencies and commodities.” Sounds very much like the clone funds reported last week, but beyond the academics trying their hand at it, Prestbo, citing the report, says the product is a Merrill Lynch-pin. Quoting the report: “Merrill Lynch has an investable index which emulates diversified hedge-fund exposure with complete transparency, low fees, daily liquidity, with no direct investment in hedge funds.” Then there’s the second new type, reportedly the handiwork of Swiss Julius Baer, which Prestbo says, will replicate “similar strategies that hedge funds execute, using a systematic rules-based methodology instead of active management.” Merrill Lynch, notes Prestbo, recognizes that these new indices can’t do all that real hedge funds do, that “there are also risk in that the statistical techniques must look in the past to estimate how hedge funds will behave in the future. The Merrill Lynch report went on to state that if hedge funds change their investment style quickly, the mimickers may suffer “as they require a certain number of return observations in order to update their asset weightings.” Add to that the question of “which tradable factors to include in the replicating portfolios and whether these factors need to change over time.” In addition, the replicas may not be able to work under all market conditions, and because of their nature they may be more volatile than hedge funds. The missing link that would connect these imitators with the real hedge funds, concludes Prestbo, is the human factor – the active manager’s skill – which he say accounts for about 40% of a fund’s net return.