Following the poor returns of the last bear market, institutional investors have recognised the need for diversification in their investment portfolios. Post-Myners, many pension funds are seeking to match their liabilities by investing in alternative asset classes such as hedge funds. The mainstreaming of an industry that has traditionally been shrouded in mystery has led to the emergence of a number of investable hedge fund indices launched by well-known providers that first built their reputation in the equities market. Now that these indices are widely available, investors in hedge funds are faced with even more choice when looking to make their first investment.
Although some may see the investor’s dilemma as a clear-cut decision between investing in a hedge fund index or in a fund of hedge funds, the reality is not nearly so simple. John Godden, managing director of HFR Europe, remarks: “Indices and fund of funds are two very different products. As a passive product, indices represent a viable alternative to fund of hedge funds from a cost perspective. But in the case of a fund of funds, the investor pays for the fund of hedge fund manager to undertake active and strategic manager selection decisions to meet particular performance, risk and correlation requirements.”
According to Charles Beazley, global head of institutional and alternative investments at Gartmore, investors need to reconsider their approach to indices. He says: “Rather than an alternative to hedge fund of funds, investable indices should be looked at as a particular format of hedge fund of fund investment. Investors need to clearly understand the active manager selection, selection bias and constraints that investable index contains and the resulting potential for significant tracking error versus the uninvestable indices”.
However, despite their separate characteristics, both products are seen as possible entry points into the hedge fund universe by first-time investors and might therefore find themselves competing for the same clients. Providers of investable hedge fund indices claim to be able to compete with fund of hedge funds on a number of factors, including transparency and due diligence. Investors often derive a great deal of comfort from the brand name of the provider, which will carry out a significant amount of due diligence on behalf of the investor. David Blitzer, Standard & Poors, says: “Our hedge fund index has a clear mix of strategies and a good deal of due diligence is carried out on the funds. We choose funds that are representative of institutional quality”. According to Blitzer, hedge fund of funds tend to be less transparent than indices and often don’t have daily pricing. He adds: “We offer daily pricing and monthly finalised pricing, which gives investors a sense of what’s happening”.
But investors should still be prepared to educate themselves about the asset class and carry out their own due diligence. According to Oliver Schupp president of the CSFB/Tremont index, not all indices are objective. He adds: “Some indices, like fund of hedge funds, are very subjective. But, if done properly, they can represent a transparent solution for pension funds.” In Schupp’s opinion, the main advantage of investable hedge fund indices is their simplicity. He continues: “From an institutional perspective, indices are a known quantity as changes are only made according to a pre-determined schedule.”
Whether a first-time investor should choose one over the other depends on their particular needs as well as their level of knowledge. Schupp says: “A rules-based approach as used by some investable hedge indices represents a valid alternative to fund of hedge funds for institutional investors. Whether it should be the first step into hedge funds for a pension fund depends on what it is looking for. If it wants to access the whole asset class then it is the right decision. But if the institution needs something more dedicated or its focus is on actively managed fund of hedge funds then an index is obviously not the right choice for that investor”. Godden adds: “The first thing we do with a new client is to ask what their requirements are. For some investors, a passive tracker in hedge funds is enough. But for others who need something more defined and more complex, it makes more sense to use the index as a core investment approach and use a a more active fund of hedge funds for a satellite approach”.

Indices can also be used for strategic asset allocation and tactical strategy selection by those who know what they’re doing. Godden explains: “For instance, they may be used by funds of funds that have identified a strategy but haven’t identified a manager yet. They can then be used to park the money until a single hedge fund manager is found.”
Despite the flexibility of certain indices, some remain unconvinced and warn investors not to use indices as a proxy for funds of hedge funds. Beazley says: “While their format can be attractive to some investors, at Gartmore we believe the needs of the majority of institutional investors are better served by mainstream fund of hedge fund managers and direct investments”.
As investable hedge fund indices are relatively new, it remains to be seen whether they will perform better than fund of hedge funds in the long-term. Yet it is clear that they have had a significant impact on the development of the industry.
According to figures by HFR, approximately 25% of hedge fund assets raised last year went into indices. There is no doubt in Schupp’s mind that indices are here to stay. He says: “It is clear that indices will continue to offer a viable solution for investors in the future but whether it will ever come to the same ratios as in the equity world, is still too early to say. The ones that do succeed will offer a plain, objective and unambiguous index”.
Until recently, it was difficult to justify a passive approach to an asset class that has always been defined by its active, alpha-generating nature. But now that hedge funds are finding it difficult to replicate the double-digit returns of the golden decade of the 1990s, some investors are beginning to question the amount of alpha added by so-called active managers.
Investable hedge fund indices can play a role in this new environment: managers can use them as a benchmark to calculate the alpha they provide through their portfolio management strategy and investors can use them as a lower cost alternative to actively managed fund of hedge funds. But investors going the index route should be prepared to make compromises of one kind or another.
It is down to the investor to work out whether the design of the index reflects their particular investment needs and whether the index offers a sufficient representation of the universe they want to invest in. The message is clear: indices can be useful when used correctly, but they should not be used as a panacea for investing with no prior knowledge of the asset class.

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