The challenges of benchmarking diversified
alternative investments
Eric Stein, CFA
Senior Director, Investments
September 2013
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Diversified alternative investments include a wide array of investments that can have very
different characteristics and investing styles.
Benchmarking is a useful and purposeful tool in evaluating asset classes and managers.
However, compared to traditional investments, there are additional challenges when it
comes to benchmarking diversified alternative investments.
With the diverse set of strategies included in the diversified alternative universe,
there is no single benchmark for performance evaluation purposes that is appropriate
for all strategies.
Before pursuing this topic further, let’s define two key terms:
Diversified alternative investment: McGladrey Wealth Management defines diversified
alternative investments as those that represent a different implementation strategy from
traditional investments, often with looser constraints (e.g. ability to short, increased use of
derivatives). These investments are designed to complement traditional equity and fixed
income investments and reduce, or buffer, overall portfolio volatility. Specifically, we aim for the
diversified alternative category as a whole to have a volatility range of between 6-8% per year
on average.
Benchmark: A benchmark is a standard against which the performance of an investment can be
measured. As an example, managers in the domestic large cap core equity category most often
use the S&P 500 or Russell 1000 as their benchmark. Said differently, the manager’s goal is to
beat, or outperform, the returns of these benchmarks over various time periods. In order for
benchmarks to be effective, the CFA Institute believes benchmarks must be:
 Unambiguous (i.e. securities and their weights are clearly identifiable)
 Investable (i.e. it is possible to hold the benchmark)
 Measurable (i.e. returns can be frequently measured)
 Appropriate (i.e. the benchmark is consistent with the manager’s investment style)
 Reflective of current investment opinion (i.e. the investments are known and understood)
 Specified in advance (i.e. the benchmark is constructed prior to a performance review)
Since McGladrey WM started investing in diversified alternatives, we have utilized the HFRI
Fund of Funds Composite Index (HFRI FoF) as the category benchmark. The HFRI FoF is a
non-investable index comprised of 500 constituent funds of hedge funds and is calculated on an
equal weighted basis. Only fund of funds are included in the index and they must each have at
least $50M under management and have been actively trading for at least twelve months.
There are some positive aspects of having the HFRI FoF as the benchmark for diversified
alternatives:
 As a fund of funds structure, the HFRI FoF includes most, if not all, of the broad hedge
fund strategies being widely implemented in the industry.
 The HFRI FoF is a well known index in the hedge fund universe, created by a well
known provider in Hedge Fund Research (HFR).
However, there are also several aspects of the HFRI FoF that conflict with the previously listed
makeup of an effective benchmark:
 The reporting of hedge fund returns, unlike mutual fund returns, is voluntary.
 The voluntary reporting of hedge fund returns can lead to survivorship bias, which is
when performance returns from investment managers are excluded from a database
because the manager has gone out (or is going out) of business or no longer wishes to
report results due to poor performance.
 The HFRI FoF can also be subject to backfill bias, which is the practice of investment
managers not reporting their performance results to databases until after a period in
which they have success. In other words, only when the manager achieves success do
they report their positive returns (and the historical returns are backfilled). It is assumed
the manager would choose to not report returns at all if the returns were poor.
 As a result of these and other biases, published returns for the HFRI FoF likely
need to be adjusted downward.
 The HFRI FoF is a non-investable index.
 The returns for the HFRI FoF are only available and published on a monthly basis
whereas most other index returns are published daily.
 The diversified alternative investments that McGladrey WM currently recommends have
different investing styles and characteristics. There is no one index that is appropriate
for each distinct investment.
The issue of benchmarking diversified alternatives comes down to what a benchmark is
ultimately used for. As described earlier, a benchmark is a standard against which to be
measured. However, if the benchmark is not a fair comparison or a similar strategy to the
investment being reviewed, how can you compare performance? In short, you shouldn’t
make the comparison.
Therefore, we think of the HFRI FoF as more of a proxy or representative peer group for the
entire diversified alternatives category rather than something each individual investment should
be compared against or is trying to outperform. Instead, we choose to judge the merits of
each diversified alternative investment vs. their own distinct benchmarks to test whether
they are meeting their stated objectives.
As always, please contact your Wealth Management advisor with any questions or comments.
800.274.3978
www.mcgladrey.com
This publication does not constitute professional or investment advice. Financial information is for illustrative purposes only, and
past performance is not indicative of future results. The indices discussed are unmanaged and do not incur management fees,
transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index.
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