Hedge fund indices:
how representative
are they?
Pictet Alternative Advisors SA
Hedge fund indices aim to quantify the
returns of the hedge fund universe. In doing
so, they offer a relative basis for comparing
absolute hedge fund performance. However,
investors should pay careful attention to index
construction, which can easily misrepresent
performance and may not fully reflect the
complexity of the industry.
Hedge fund indices
Page 4
What are the origins of
hedge fund indices?
How is a hedge fund
index constructed?
How does the concept
of an ‘index’ apply to
hedge funds?
Hedge fund databases
Page 5
Do hedge fund
databases reliably
represent the hedge
fund universe?
What other database
biases exist?
The methodologies
of index providers
Page 7
How do methodologies
differ between
providers?
What is an investable
hedge fund index?
Fund of hedge
fund indices
Page 9
Do FoHF indices
provide a better
representation of the
hedge fund universe?
Investing in hedge
fund indices
Page 10
How can you invest in
a hedge fund index?
What is a hedge fund
index replicator?
Why is hedge fund
index investing popular?
2
Hedge fund indices: how representative are they?
Summary
An investor welcomes the opportunity to compare their
investments to a credible benchmark. For instance, a UK large
cap equities portfolio would typically use the FTSE100 as a
benchmark, since the index represents over 80 per cent of
UK market capitalisation.
Hedge fund investors also value a trustworthy benchmark.
However, the complex nature of hedge fund investments creates
difficulties in the construction of a suitable measure. In addition,
hedge fund database reporting introduces a number of biases that
distort the true picture of hedge fund returns.
Nevertheless, this has not inhibited their widespread construction
and use throughout the industry. In the absence of a more reliable
alternative, it remains vital that investors understand the specific
characteristics of these indices.
1
Source: Hedge Fund
Research.
With hedge fund assets totalling over USD 3.0 trillion across more
than 10,200 hedge fund vehicles at June 20151, an accurate measure
of hedge fund performance is unquestionably justified.
What was the performance of Global Macro managers in 2008 and 2009?
a) +5.6% and -8.8% or
b) -21.3% and +36.2%
See page 11
Summary | Hedge fund indices | Hedge fund databases | The methodologies of index providers | Fund of hedge fund indices | Investing | Conclusion
3
Hedge fund
indices
What are the origins of hedge fund indices?
Hedge fund indices have tracked the exponential growth of hedge fund assets,
first appearing in the 1990s. Their use has grown in line with investor demand.
Typically, hedge fund indices are employed in asset allocation studies, proving
vital in assessing the impact of hedge fund investments on a broader asset
mix. Hedge fund indices also offered the first opportunity to benchmark a
manager’s performance in an otherwise highly secretive industry. This was
further extended to monitor a manager’s style drift and investment discipline.
How is a hedge fund index constructed?
The construction flow of a hedge fund index begins with the hedge fund
manager reporting the funds’ description and performance to a hedge fund
database. As hedge funds are private placements, the choice of database and
which fund to report is completely voluntary and self-selected. A manager
can therefore choose to report its best performing fund to only one index
provider or not to report a poorly performing fund.
The hedge fund database provider aggregates the various funds that have
reported and either gives hedge fund index providers access to its database
or constructs indices itself. Typically, the database requires the hedge fund to
describe its investments universe, terms and conditions and strategy/style.
The index provider then assimilates the hedge fund database universe
according to selection criteria which vary across index providers.
At this stage, the index provider constructs an index with a new, condensed
hedge fund universe that can be further broken down into sub-indices covering
the variety of hedge fund strategies and styles.
HOW A HEDGE FUND INDEX IS CONSTRUCTED
Hedge fund
manager
Hedge fund manager
opts not to report hedge
fund to database
Hedge fund
database
Hedge fund database
filters funds according
to selection criteria
Hedge fund manager
voluntarily reports hedge
fund to database
Hedge fund
index provider
Hedge fund
index
Hedge fund index provider
filters its universe of open
and closed hedge funds and
categorizes into sub indicies
Source: Pictet Alternative Advisors SA
How does the concept of an ‘index’ apply to hedge funds?
By definition, hedge funds are absolute return investment vehicles. Therefore, the
term ‘hedge fund index’, which introduces the concept of relative performance, is
immediately counter-intuitive. Although a hedge fund manager operates within
a definite strategy, each manager executes the strategy in his own manner. This
is the source of any alpha, or skill of a manager, which varies across hedge funds
and is a source of hedge fund performance.
The existing universe of hedge fund indices offers the investment community
several options. Hedge fund indices can be strategy specific, equally weighted,
asset weighted, ‘investable’, or ‘non-investable’.
4
Hedge fund indices: how representative are they?
Hedge fund
databases
2
Source: Performance
Benchmarks and
Survivorship Bias for
Hedge Funds and
Commodity Trading
Advisors. Park, J.,
S. Brown and
W. Goetzmann, 1999.
Reported in Hedge
Fund News.
Do hedge fund databases reliably represent the hedge fund universe?
An index should represent a general proxy for an industry. Because of
the characteristics associated with the hedge fund industry (i.e., private,
unregulated offshore structures), hedge fund databases are subject to several
biases that militate against an accurate representation of hedge fund strategies
and consequently distort performance. Some biases inflate performance
while others may skew index performance downwards. Hence they may
only be able to provide a biased estimation of the ‘true’ hedge fund universe.
Cumulative studies have estimated the impact of biases on performances
to range between 0.7 per cent to 10.7 per cent per annum.2
What is ‘self-selection bias’?
As the hedge fund universe consists mainly of private structures, there is no
legal requirement to report performance to the general public. Consequently,
reporting to a hedge fund database becomes completely voluntary. This leads
to what is known as self-selection bias. Further, there is no obligation to report
to all databases and the manager can therefore report to only two or three
databases if they so desire. Voluntary reporting is driven by incentives.
A manager may opt not to report its performances due to either a bad track
record—creating an upward bias—or because a fund with good performance is
closed and wishes to retain its secrecy—leading to a downward bias. Managers
understandably prefer to report good track records. A 1999 study suggested
that self-selection bias causes a performance deviation of 1.9 per cent annually.2
INDUSTRY COVERAGE BY HEDGE FUND DATABASES
CISDM
25.8%
1.9%
TASS
EUREKA
3.2%
1%
16.7%
2.4%
<1%
1.7%
12.2%
1.8%
1%
2.2%
1%
2.3%
<1%
1.5% <1%
<1%<1%
<1%
<1%
<1%
<1%
1.1%
<1%
1%
10.2%
HFR
5.8%
MSCI
Source: Inferring Reporting Biases in Hedge Fund Databases from Hedge Fund Equity Holdings, February 2010
http://ssrn.com/abstract=1536886, V. Agarwal, et. al.
Figures indicate percentage of funds covered
The diagram above shows that less than 1 per cent of the hedge fund industry
reports to all databases, highlighting the unrepresentative nature of hedge
fund databases.
Summary | Hedge fund indices | Hedge fund databases | The methodologies of index providers | Fund of hedge fund indices | Investing | Conclusion
5
A study by Fung and
Hsieh in 2000 estimates
a performance deviation
of 3.0 per cent annually
as a result of ‘instant
history bias’.
A study by Barry in
2003 estimates a
performance deviation
of 3.7 per cent annually
as a result of
‘survivorship bias’.
Side-pockets: hedge
funds with a proportion
of potentially or actually
illiquid assets may
separate those assets
into ‘side-pockets’
(subject to restrictive
redemption conditions),
which allows investors
to raise cash by
redemptions against the
liquid portion of the
fund’s portfolio.
6
What is ‘instant history bias’?
Also known as ‘backfill’ or ‘retroactivity bias’, instant history bias is defined
as the historical restatement of the index following the addition of a fund.
Depending on the provider, there are two instances where instant history
bias occurs. First, a database that rebalances the historical returns of an
index every time a new fund is added suffers from instant history bias.
Second, and more commonly, instant history bias occurs at a launch of an
index. For instance, if a new index launches in 2010, it can decide to backfill
returns since 2000, therefore only selecting funds that have a suitable track
record, instantly disregarding a segment of the universe that has a shorter
track record. In both cases, inclusion of funds with good track records leads
to overestimating the industry’s performance, while those with a bad track
record or dead funds are not reported.
What other database biases exist?
‘Survivorship bias’ or ‘liquidation bias’ occurs when constituents are removed
from an index. In the case of hedge funds, survivorship bias commonly occurs
when obsolete funds or ‘blow-ups’ cease to report to a database, which creates
an upward bias for a given index. In addition, as private placements, hedge
funds may also choose to stop reporting funds which have recently closed to
new investors. This would result in a downward bias.
Database biases may also be aggravated by a manager’s selective choice of the
share class to report. For example, the share class reported may not be open to all
qualified investors, or the performance reported may not include ‘side-pockets’.
Hedge fund indices: how representative are they?
The methodologies
of index providers
HEDGE FUND INDEX PROVIDERS AND THEIR CHARACTERISTICS
Barclay Hedge Fund Indices
Dow Jones Credit Suisse Indices
EDHEC Alternative Indices
Eurekahedge
Hedge Fund Intelligence Indices - HFI
HFR Hedge Fund Indices
Start
date
Number of
sub-indices
Equal or
asset weighted
Investable or
non-investable
1980
1994
1997
2000
1998
1990
27
10
13
10
61
28
equal
asset
equal
equal
equal
equal
both
both
non-investable
non-investable
non-investable
both
Source: Pictet Alternative Advisors SA; An introduction to Core Topic in Alternative Investments, Mark J. Anson
How do methodologies differ between providers?
Typically, the first area of difference is the decision on selection criteria for
fund inclusion. For instance, a provider may exclude any hedge fund with less
than a 12-month track record, or only include hedge funds which have assets
under management greater than USD200 million. Other criteria that vary
between providers can include constraints on operations, underlying financial
instruments or liquidity schedules. In some cases, index providers will even
go as far as to perform a full due diligence of the reporting hedge funds.
Finally, with the creation of subsequent sub-indices, some providers segment
their universe into investable and non-investable hedge fund indices.
What is an ‘investable’ hedge fund index?
An investable hedge fund index is an index constructed only of hedge funds
that are open to investment. Construction of investable indices is usually
concentrated so that an index provider can easily replicate the index to meet
client needs. Both characteristics contribute to an even smaller hedge fund
universe, resulting in significant heterogeneity across providers. Investable
hedge fund indices respond to increased demand from those whose resources
limit their ability to run an end-to-end hedge fund investment program.
Note, however, that contrary to its ostensible meaning, investable does not
define an index in which investments can be made. Investments into hedge
fund indices are achieved via hedge fund index products and not directly into
the indices themselves. Hedge Fund Research (HFR) currently publishes over
70 investable hedge fund indices, under the acronym HFRX.
What is a ‘non-investable’ hedge fund index?
A non-investable hedge fund index is an index constructed using both open
and closed hedge funds. Non-investable indices, while still representing a
subset of the industry, are intended to give a fairer representation of the
wider performance of hedge funds generally, by including hedge funds
which both can and cannot be invested in. The indices can also be broken
down into strategies and styles. For instance, the HFRI indices, published
by Hedge Fund Research, include over 25 non-investable indices. Note that
not all index providers construct non-investable indices.
Summary | Hedge fund indices | Hedge fund databases | The methodologies of index providers | Fund of hedge fund indices | Investing | Conclusion
7
INVESTABLE AND NON-INVESTABLE HEDGE FUND INDEX CHARACTERISTICS
Investable
Non-investable
• Constituents must be open to new investments
• Constituents can include open or closed hedge funds
• Suffer from database biases
• Suffer less from database biases than investable indices
• Must be easily replicable
• Larger universe to select from
• Increased biases due to tougher selection criteria
(some undergo a full due diligence)
Better estimators of the hedge fund universe
• Construction more concentrated therefore have higher degree of
heterogeneity
Poor estimators of the hedge fund universe
How do selection criteria affect hedge fund index performance across
strategies and providers?
Returns of hedge fund indices can be highly dispersed because of the varying
selection criteria used by different index providers. Moreover, the cumulative
performances of an investable and a non-investable index, for the same strategy
and from the same provider, are likely to differ significantly. The performance
chart below shows that, since April 2005, the Credit Suisse All Hedge—L/S
Equity (investable) and the Credit Suisse Benchmark Index—L/S Equity
(non-investable) have a cumulative return of +95.7 per cent and +40.8 per cent
respectively: a dispersion of over 54 per cent! The performance between
two providers publishing indices on the same strategy also shows
considerable dispersion. Over the same period, the HFRI Equity Hedge
index (non-investable) and Credit Suisse Benchmark index—L/S Equity
(non-investable) show a difference of over 29 per cent.
HEDGE FUND INDEX DISPERSION
Apr 2005 = USD100
200
HFRI Equity Hedge Index
HFRX Equity Hedge Index
CS Long/Short Equity Index
CS All Hedge Long/Short Equity Index
180
non-investable
+95.7%
+66.7%
160
non-investable
+40.8%
140
investable
120
+9.6%
100
investable
80
60
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: Pictet Alternative Advisors SA, data as at 30.06.2015
8
Hedge fund indices: how representative are they?
Fund of hedge
fund indices
A study by Fung and
Hseih in 2000 also
estimated that instant
history bias for a FoHF
is approximately 50 per
cent less than for hedge
fund indices.
Do fund of hedge fund indices provide a better representation of the hedge
fund universe?
Fund of hedge fund (FoHF) indices are constructed using FoHFs which have
decided to report to databases. In comparison to hedge fund indices, FoHF
indices include direct representation of hedge fund share classes that may not
otherwise be reported. This reduces a database’s self-selection bias. Further,
when an underlying hedge fund liquidates, blows up or sets up side-pockets,
the investing FoHF does not restate historical performance. All these factors
contribute to a better representation of the hedge fund industry, while also
limiting the database biases described above.
What are the limitations of fund of hedge fund indices?
While a better reflection of the hedge fund universe, FoHF indices still
contain biases of their own. A FoHF typically undertakes thorough due
diligence and would therefore invest in top performing hedge funds, avoid
strategies that demonstrate high liquidity risks and exclude funds exposed to
pitfalls. Furthermore, the hedge funds in which FoHFs invest in include
tactical cash allocations, whereas hedge fund indices are typically 100 per
cent fully invested. Unlike a direct hedge fund investment, investments in
FoHFs incur a double layer of fees which dilutes performance. FoHF indices
also suffer from self-selection bias.
How does fund of hedge fund index performance compare across providers?
FoHF indices also exhibit a wide dispersion between providers. The chart
below compares four FoHF indices, each with a common track record since
December 1999. Over the fifteen year period, there is a cumulative difference
of 22 per cent between the highest and the lowest performance. Whether the
performance of the pure hedge fund index—the InvestHedge Composite
index—is any more reliable is difficult to assess, since it sits mid-way between
the two extremes.
DISPERSION ACROSS FOHF INDEX PROVIDERS
Dec 1999 = USD100
220
HFRI Fund of Funds Composite Index
Eurekahedge Fund of Funds Index
InvestHedge Composite Index
EDHEC Funds of Funds
200
180
160
140
120
100
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Source: Pictet Alternative Advisors SA, data as at 30.06.2015
Summary | Hedge fund indices | Hedge fund databases | The methodologies of index providers | Fund of hedge fund indices | Investing | Conclusion
9
Investing in
hedge fund
indices
How can you invest in a hedge fund index?
Investors assume that investments into a hedge fund index can be made via
investable hedge fund indices. However the term investable indicates merely
that its constituents are open to investment, rather than an index in which
investments can be made. Hedge fund index investing is achieved via products
known as trackers.
What is a hedge fund index tracker?
A hedge fund index tracker is a collective investment vehicle designed to ‘replicate’
the performance of a hedge fund index by investing in the underlying hedge funds.
What is a hedge fund index replicator?
Replicators offer a synthetic hedge fund exposure by investing in market factors.
They mainly seek to replicate non-investable indices and are constructed using
three approaches: factor analysis; dynamic trading or payoff/distribution
replication, or reverse engineering/bottom-up approach.
Why is hedge fund index investing popular?
Trackers and replicators create a source of hedge fund beta in a single product.
Access to the hedge fund universe via index products offers a cost efficient
alternative to FoHF investments because there is no double layer of fees.
Furthermore, they are considered resource efficient, as they eliminate the need
for a dedicated hedge fund selection team. Index products also usually offer
daily liquidity with no lock-ups and typically have lower fraud risk, as they
replicate hedge fund returns via traditional financial instruments such as
futures or exchange traded funds (ETFs). However, one of the main drawbacks
of hedge fund index products is a drag on performance.
What is hedge fund beta (‘alternative beta’)?
While alpha (manager skill) is the element of returns in a portfolio that cannot
be explained by risk factors, beta is the portion of returns that can be explained
by risk factors. In other words, beta is a measure of the systematic risk of a
financial instrument relative to the market. Hedge fund indices may therefore be
considered to have introduced a beta for the hedge fund universe, to the extent
that managers following the same strategy employ a similar investment process.
That part of returns due to investment style or process represent a common risk
factor in the strategy, and are known as ‘hedge fund beta’ or ‘alternative beta’—
explaining an element of strategy returns.
How does a FoHF index performance compare with a hedge fund index tracker?
The chart below demonstrates the outperformance of a FoHF index versus a
hedge fund index tracker. It can be argued that the opportunity cost of investing
in a tracker versus a FoHF is a loss of performance, despite the operational
efficiencies mentioned above.
FOHF INDEX VERSUS HEDGE FUND INDEX TRACKER PERFORMANCE
Dec 2003 = USD100
160
HFRI FoF Diversified Index
HFRX Global Tracker Fund
150
140
130
120
110
100
90
80
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Source: Pictet Alternative Advisors SA, data as at 30.06.2015
10
Hedge fund indices: how representative are they?
Conclusion
Which index should be used?
In theory, to monitor the global performance of the hedge fund universe or
when undertaking an optimal portfolio allocation study, FoHF indices, either
composites or strategy indices, are the most reliable. However, in practice,
many investors gravitate towards the Dow Jones Credit Suisse and HFR hedge
fund indices. Use of these must come with an understanding of the biases
discussed above.
To benchmark fund of hedge fund performance, multi-strategy FoHF indices
offer the most relevant reference. In terms of benchmarking a thematic FoHF,
then single strategy FoHF indices are most suitable.
Comparing FoHF indices with a diversified hedge fund portfolio of
concentrated investments, managed by Pictet Alternative Advisors SA,
dispersion is reduced. Selecting the most appropriate index to compare a
FoHF with depends on the profile of the underlying funds. In this case the
HFRI FoF Diversified index is most closely aligned with the portfolio.
Understanding that major differences exist across hedge fund indices is
fundamental to an investor who wishes to be able to benchmark the
performance of an individual hedge fund or an FoHF against the industry
as a whole.
When an investor wishes to estimate the performance of the hedge fund
industry, understanding that this differential exists across hedge fund indices
and FoHF indices is also fundamental.
Track record of
PAA concentrated
multi-strategy hedge
fund portfolio, Mosaic
class J, since inception.
FUND OF HEDGE FUND INDEX DISPERSION
June 1994 = USD 100
450
HFRI FoF Composite Index
HFRI FoF Diversified Index
Diversified HF Portfolio³
400
350
300
250
200
150
100
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1997
1998
1996
0
1994
50
1995
3
Source: Pictet Alternative Advisors SA, data as at 30.06.2015
Answer to the question on page 3: both a) and b) are correct.
HFRX Macro index posted +5.6% and -8.8% in 2008 and 2009 respectively. Credit Suisse
Blue Chip Global Macro Hedge Fund index posted -21.3% and +36.2% in 2008 and 2009
respectively.
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Summary | Hedge fund indices | Hedge fund databases | The methodologies of index providers | Fund of hedge fund indices | Investing | Conclusion
11
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