S&P to Launch Hedge Fund Index By John Spence May 8, 2002

There seems to be an index for just about anything these days, so why not a benchmark for hedge funds? Standard & Poor's said it is set to launch an index that seeks to tame this unique asset class.

The new index will be made up of 40 funds broken into three sub-indices (*see full description at bottom). S&P said the index will be equal-weighted, rather than cap-weighted, to avoid temporary overbalancing of "currently popular strategies."

The move represents the first time a recognized index provider has attempted to create a standardized investable benchmark for the colorful world of hedge funds, a task that seems most akin to cat herding. Hedge funds are not regulated as strictly as mutual funds, and hedge fund managers for obvious reasons don't particularly like to share any information about their portfolios.

S&P said the hedge funds must pass a series of quantitative screening criteria to ensure that they conform to their stated strategy's return and risk characteristics. Hedge funds must also agree to provide daily transparency, and S&P will post daily index values on its website.

S&P has already granted PlusFunds exclusive license to develop investment products based on the index. Despite the daunting task of indexing the hedge fund world, both firms believe investors will be drawn to the diversification properties of the future products, citing the low correlation of most hedge funds with traditional asset classes.

Peter Roffman, a vice president at Standard & Poor's Portfolio Services, filled us in on some of the details of this quirky new creature.

IF: Who would be most interested in a hedge fund index product?

PR: Institutional investors, including pension funds, and high net worth investors who want a broad exposure to the hedge fund market, and investors looking for a benchmark for individual fund performance or benchmark data for the asset class as a whole.

IF: Would the selection process be committee-based?

PR: Yes, following on the methodology of all S&P indices, the index will be managed by a committee who will rebalance the index annually and meet regularly to continue the due diligence process and make any necessary changes to the index.

IF: Why is the index equal-weighted, rather than capitalization-weighted?

PR: Because we feel that to correctly represent the asset class, we need to give a broad spectrum of exposures. Cap weighting tends to favor where the hot money is flowing.

IF: Would it be possible to launch an ETF on the hedge fund index when ETFs require real-time transparency?

PR: While an ETF would be difficult for the reason you mention above, it is possible at some point that derivatives products could be developed that track the index.

IF: What is the cut-off for hedge fund inclusion in the index in terms of assets under management?

PR: We generally prefer the manager to have at least $100-200MM in assets under management to ensure business continuity and validity of the track record. And, component funds must offer at least $100M in new money capacity as a criterion for inclusion in the index. This helps us ensure the investability of the index.

IF: Why don't hedge funds behave like most other funds?

PR: This answer varies by the type of strategy under discussion. Typically it is because the securities purchased are not correlated with the Equity Markets or Fixed Income Markets, or because managers can take short positions, which can lower correlation even more.

IF: How many hedge funds are there now, and how many would be eligible for the index?

PR: Estimates are around 6,000. Since no one has data on all the funds, it's difficult to guess the number eligible. Our screening process starts with examining funds that fit into one of the 9 major styles represented in the Index, which we believe to be representative of hedge fund investing today. Once a fund is classified, it is screened for style purity, asset size, tenure, and a number of qualitative due diligence and quantitative screening techniques. Openness to new investment and willingness to grant daily transparency are also eligibility criteria.

We've selected the 40 as our target number of funds to start with because numerous academic and internal studies have shown that a sampling of 30 to 40 funds is sufficient to capture characteristics of a large portfolio of hedge funds. Beyond 40 funds, the diversification benefits start to drop off significantly so we believe that our index will be representative and appropriate for use as a benchmark, while maintaining investability.

IF: How will the S&P Hedge Fund Index be used by investors?

PR: The S&P Hedge Fund Index can be used by investors to track or benchmark their own hedge fund portfolios to determine if their managers are adding value. It can also be used to determine how various hedge fund investment strategies react to specific market conditions with only a minimal lag. We anticipate that funds and derivative products will be developed from the index giving investors direct exposure to the hedge fund asset class.

IF: When might we see products based on the index?

PR: The index has been licensed to PlusFunds who are expected to create an investment product tracking the index sometime in the third quarter.

*The Index will contain 40 funds divided into three sub-indices: Arbitrage, Event Driven and Tactical, which in turn represent a total of nine specific strategies. These strategies include: Macro, Equity Long/Short, Managed Futures, Special Situations, Merger Arbitrage, Distressed, Fixed Income Arbitrage, Convertible Arbitrage and Equity Market Neutral.