Hedge Fund Strategy Indices By Rahul Seksaria 1999

Hedge Fund Research, a full service financial consulting firm specializing in alternative investments, recently launched indices for a number of hedge fund strategies (available on Bloomberg, Bridge and at www.hfr.com). The indices capture the core, non-leveraged return generated by each strategy and enable institutional investors and high net-worth individuals to develop an indexed portfolio based on one or more of these strategies.

"An increasing number of individual and institutional investors believe that prudent investing requires transparency at the portfolio level to understand risk and reward characteristics of the investment and to prevent style drift into higher risk exposures, whether through higher leverage or lower quality investments. There is also a growing interest in strategies with identifiable and repeatable sources of return," says Joseph Nicholas, Chairman and CEO of Hedge Fund Research. The HFR daily strategy indices provide a core benchmark for each strategy and can be used as a basis for evaluating strategy variation and the use of leverage.

The company structures single and multi-manager hedge fund portfolios for institutional investors and high net worth individuals. HFR provides daily risk management and fund valuation, due diligence, manager selection and asset allocation services.

HFR currently has five active indices tracking different hedge fund strategies, with numerous others in the pipeline. The active indices are: (1) Convertible Arbitrage (2) Equity Hedge (3) Event-Driven (4) Risk Arbitrage (5) Statistical Arbitrage. Strategy definitions can be found at the HFR website. The daily strategy indices are characterized by:

• Full Transparency
• Daily Valuation
• Purity of style and adherence to style
• Non-leveraged returns
• Investable

What is full transparency?

Transparency is the ability to review a manager's portfolio to the factors that must be considered when making prudent investment decisions. Usually, the term is used to refer to the ability to review the underlying instruments and positions. The information on fund holdings should ideally come from a third party, such as the prime broker or custodian, rather than from the manager, and the instruments should be priced independently and not by the manager. Daily transparency first emerged as a tool to monitor risk. But it also makes daily pricing possible, which in turn has opened the door to HFR's daily strategy indices and new products and structures for accessing hedge fund strategies, such as mutual funds and strategy index funds.

Construction techniques and calculation methods

• Purpose - The purpose of these indices is to serve as a performance benchmark for investment managers and to aid in the asset allocation process.
• Membership - Based on detailed position data on investment managers, HFR selects pure style managers for each index. Pure style is independent of leverage or geographic investment, but rather focuses on the defined characteristics of each strategy.
• Exclusions - Investment management accounts that contain less than $5 million USD in assets are not included in the indices.
• Valuation - Portfolio securities are valued on a daily basis using multiple price sources.
• Re-balancing - As new portfolios are added to an index, the index is not re-balanced, as these are equally weighted indices. Each portfolio represents an equal portion of the index.
• Adjustments - Cash flows into and out of portfolios are taken into account when compiling performance figures. Leveraged portfolios are de-leveraged according to debit balances (for example, a $300k debit balance in a $1 million portfolio would indicate 300,000/1,000,000 = 30% leverage, so the performance for that portfolio would be reduced by 30% for that particular day).

The information below about the hedge fund industry has been supplied by Hedge Fund Research.

Growth of the Hedge Fund Industry

The hedge fund industry has experienced dramatic growth in the 1990's with assets under management going from $6.36 billion in January of 1990 to $400 billion in October of 1998. Prior to 1990, this private investment industry could hardly have been called an industry. Fueled by the longest bull market in history and rapid gains in technology that have increased the availability and accessibility of information about these private investment vehicles, investors have allocated capital to hedge funds. Many investors have done so because hedge funds offer different sources of return and risk profiles than traditional stock and bond portfolios.

As hedge fund assets have grown and demand from high net worth individuals and institutional investors for information about hedge funds has increased, HFR has emerged as a source of specialized information and advice for those who are considering hedge fund investments.

Understanding the Industry

Like the term "mutual fund," "hedge fund" does not refer to a specific investment approach or asset class. And while there is no formal definition, "hedge fund" generally describes a variety of alternative investment strategies that utilize liquid and semi-liquid instruments, and which are usually accessed by investing in private commingled funds. Most, but not all, make use of short-selling and hedging techniques, as well as various forms of leverage-although there are funds that are neither hedged nor leveraged. The key to understanding the industry is realizing that it consists of a diverse mix of sometimes unrelated investment strategies. During the 1990's rapid gains in technology have leveled the financial playing field. As a result, many boutique money management operations utilizing specialized investment strategies have emerged and changed the strategy composition within the hedge fund industry.

The graphs below show the composition of hedge fund strategies in 1990 and 1999.

These strategies may be added to a traditional portfolio to enhance performance, to hedge against market declines, to provide diversification into other markets and instruments or to introduce non-correlating exposures. Strategies should be selected that will meet the investor's objectives and constraints. Because each of these strategies are understandable, and most hedge fund managers pursue only one (or a related group) of approaches, investors should set aside the term "hedge fund" and focus on the risk and reward characteristics of the strategies. In addition to understanding the underlying strategy, investors should comprehend the method of accessing the strategy (corporation, limited partnership, unit trust, mutual fund, separate account) as well as details including domicile, tax issues, custody and control, redemption provisions, fees, advisor discretion and lock-ups.

The key to the industry is to understand the underlying strategies' risk and return characteristics and the market factors that impact them. In this, hedge funds are similar to other investment opportunities: analysis of returns is incomplete without an understanding of the potential risks.

Assessing the Risks

There are two basic types of risk that hedge fund investors are exposed to: 1) risks associated with the investment strategy, and 2) risks associated with accessing that strategy. Like any investment strategy, a hedge fund strategy involves risks specific to the strategy and the markets it is exposed to as well as the risks that can be attributed to the particular style of the manager, such as use of leverage or hedging techniques.

Assuming that the strategy risks are understood by the investor and deemed acceptable, there is still the risk of accessing the strategy. Usually these risks are attributable to "blind" investing - investing in a fund that does not provide adequate information and asset custody. In such a situation, the investor is left without information and control of his investment, and may find it difficult to hold the fund manager accountable for his investment decisions.

©1999 IndexFunds.com