It is no secret that the hedge fund circuit is seeing more traffic these days. The number of these unregulated investment vehicles has quintupled to more than 5,000 in the past seven years, and assets under management have grown at a similar pace to around e600bn, although exact figures are impossible to pin down.
With the explosion in popularity has come an increased desire for risk management. Once branded as the sleek, yet potentially dangerous, toys of the financially adventurous – built solely for high performance and prone to spectacular blowups, hedge funds are increasingly the choice of mainstream investors, which have found their investment vehicles are not taking them where they want to go. A natural evolution has been the emergence of products that seek to diversify excess risk by holding a large number of hedge funds. These fall into two principal categories:
q Funds of funds (FOFs), actively-managed portfolios of hedge funds that generally seek to achieve high returns and low volatility; and
q hedge fund index products, passively managed collections of hedge funds seeking to provide the investor with exposure representative of one or more strategies within the industry.
The concept behind funds of funds is simple and appealing: an investment manager researches many hedge funds and maintains a portfolio of the best of them, charging a fee in exchange for the potential to deliver high performance. However, evidence suggests it is quite difficult to deliver consistently better-than-average performance in a FOF. Figure 1 plots the performance of 121 FOFs in the TASS database from December 1996–November 1999 against their performance in the subsequent period from December 1999– November 2001. As the charts suggest, the correlation is not statistically different from zero.
Another study looked at the persistence of returns among top-quartile FOFs and reached a similar conclusion: Funds in the top quartile in one period were not significantly more likely than average to be in it in subsequent periods (see figure 2).
Even if one accepts that identifying a better-than-average FOF based on past performance is nearly impossible, one might still wonder about the performance of FOFs as a group: Do fund of fund managers, collectively, show skill at assembling hedge fund portfolios that consistently outperform the market? To answer this question, we compare the performance of FOFs in the TASS database to the CSFB/Tremont Hedge Fund Index, a rules-based, asset-weighted index of individual hedge funds (but not FOFs) that we take as a proxy for the hedge fund market, over two historical periods – from December 1996–November 1999 and December 1999–November 2001. In both cases, the performance of the CSFB/ Tremont Index falls near the centre on both risk and return, between the average and the median FOF performance (see figure 3). This suggests that most fund-of-fund managers have been unable to consistently assemble a group of hedge funds that outperform the market.
The inability of FOF managers to outperform a passive index does not rule out the possibility of identifying an above-average fund of funds manager; it only suggests that historically the vast majority of investors have been unable to do so. This agrees with similar empirical findings in the traditional asset management industry. For this majority, it also suggests that investing in a hedge fund index may be a worthwhile alternative to a fund of funds.
Hedge fund indices typically provide greater diversification than funds of funds: whereas a FOF may use around 25 hedge funds chosen by its management team, an index typically has 100 or more that are chosen according to size or other objective criteria. Index product fees also tend to be lower, with consequences for the return distribution: while a typical index product charges no performance fee, a typical FOF may charge a 10% performance fee (on top of the 20% charged by its constituent funds), effectively increasing the negative skew of expected returns by yielding all of the net downside but only 90% of the net upside.
Hedge fund index investing also offers targeted exposure, another important advantage for large institutional investors such as pensions and endowments. A fund of funds is typically managed to deliver performance as a standalone instrument – a strategy that may not be suitable for investors that intend hedge funds to be only a fraction of their composite portfolio. By delivering passive exposure, index products lend themselves better to portfolio construction because their composition is less likely to shift abruptly.
Sector indices tracking specific hedge fund strategies enable investors to add only those types of hedge fund strategies they find most attractive or best suited to their needs. If an investor holding primarily equities is interested in attaining diversification through a fixed-income arbitrage hedge fund portfolio, it may be easier to identify a fixed-income hedge fund sector index than to find a FOF that is both focused on fixed-income arbitrage strategies and committed to staying that way.
Finally, in many situations an actively-managed hedge fund product may not be appropriate. Regulations or tax laws in some jurisdictions favour index products over active ones, particularly in products aimed at retail markets. Pension and endowment managers also often find it easier to gain board approval for new index investments than for new active strategies. Furthermore, indices lend themselves better to structured derivatives, since their construction is less arbitrary than with funds of funds.
The unique characteristics of hedge fund indices make them well suited to the alternative investment needs of large institutional investors such as pensions, endowments and insurance companies. Because indices offer low fees and diversification benefits while delivering comparable performance to FOFs, institutions often find it easier to convince their boards of the merits of an index product than an actively-managed fund of funds. Finally, asset allocators often prefer the objective market exposure of an index to the standalone perspective of a fund of funds. As the institutional community broadens its interest in hedge funds, there is reason to believe that much of this interest will be channelled into index products.
Oliver Schupp and Jeff Bramel are with Credit Suisse First Boston in New York. Fabian Blohm is with Credit Suisse First Boston in London

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