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Hedge Fund Monthly

Proliferation of Hedge Fund Indices
Angela Pasceri
July 2002

The MSCI Hedge Fund Indices launched in July of this year is one of many products in an already crowded market, but it claims to be superior to what's on offer despite its small but growing database of 750 funds. MSCI's family of hedge fund indices is an ambitious endeavour composed of 90 indices aimed at measuring all hedge fund strategies both open and closed in minute detail.

It's very tempting at this point to say good luck. In an industry where investment style varies from manager to manager, it is very difficult to get a representative number of managers to contribute to a sub-set. Of course the issues that have plagued each of the already established indices crop up for this recent addition: survivorship bias, lightly populated sub-sets with, in some cases, three to four constituents, and the uninvestability of indices that include closed funds. Furthermore all of this data is compiled on unverified information that is volunteered by the manager. There is also no monitoring to ensure managers don't drift from their declared style.

There is probably some comfort in the fact that MSCI, already firmly established in international equities and fixed income indices, would not risk entering into an area that it did not feel was sustainable. One fund of funds manager with an international asset management firm based in Hong Kong notes that although it's too early to say, his cursory look at MSCI's hedge fund indices indicated it was likely to be the most complex one he had seen. The numerous combinations that can be created by mixing and matching indices produce a combined index more suited to fund of funds strategy or a particular market strategy within a region.

Yet, having said this, he would not use an index, not even an established one. "We're obviously aware of them but we don't use them to make any decision in any shape or form. Nor would we compare ourselves to them," he says. His argument is that fund classification is still very difficult to get right because of the diverse management styles. "A US long/short index could compromise managers that are long/short equities and managers who are long/short financial instruments, for instance in equities, bonds, convertible, indices futures, a whole hybrid of different products that are not just pure equity. It could involve managers that are net long continuously or managers that have a bias towards a short side or it could be more neutral. It's very difficult to try divide them up and put them into categories."

His firm compiles its own indices in New York, which are subsets of major strategies, to try and capture what the company believes will be more suitably matched managers within a subset of an index. "It's not like a traditional index where you have a benchmark and you're overweight or underweight and therefore it's a lot more quantifiable."

Deutsche Bank's David Zobel agrees: "They are useful tools in that they give you some insight but I don't think they can be used for benchmarking if they have issues of composition (some are equally weighted and some are market capitalisation-weighted), survivorship bias and investability." Based in Sydney, the regional head for absolute return strategies in Asia uses internally constructed indices. "We have a qualified pool of funds which made it through our due diligence and have capacity for us. If we look at that universe, to us it's a lot more meaningful." His team also has a database of about 150 Asia-based funds from which a much smaller qualified pool is drawn.

One investor we spoke with had no use for indecis: "We don't use any form of index. Our main task is to make money. Absolute return is what we do. We don't care if the index goes up or goes down," says Kenji Kodama, deputy manager, alternative investment group at The Tokyo Marine and Fire Insurance. Speaking from his Tokyo office Kodama notes that they don't even use internal indices - he refers to the market - although he does admit watching CSFB/Tremont and HFR and a few others, out of interest. Kodama's team invests in single strategy funds and since the department's inception in 2000 has met with more than 300 managers and presently holds 21 funds in his portfolio.

A Hong Kong-based hedge fund manager notes that an outcome of slowly institutionalising hedge funds through indices is that: "The indices give investors an idea of what the market is supposed to be doing - more-or-less - but you're always going to have outliers and that is going to make their jobs difficult because investors will either not invest with them or invest with them for the wrong reasons. It's dangerous."

He adds: "With the fund of funds becoming so instrumental in the growth of hedge funds and institutions allocating out to hedge funds, managers are under extreme pressure to align themselves to certain strategies absolutely, rather than implementing their own style alongside say, a long/short strategy."

Zobel disagrees; he thinks it's a bit premature to be concerned with managers giving up their individual styles for a chance to fit into a box. In a way, he posits, the issue has always been there. "The indices that exist have subsets and not every hedge fund fits neatly into those categories. We often come across hedge funds that are doing things differently and we like to assess what they're doing on their risk return profile and we're not so worried about which box they fit in."


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