Holding a diversified portfolio of hedge funds can mitigate the
specific risk associated with investing in individual hedge funds.
Access to a portfolio of hedge funds can be obtained through two
principal vehicles: fund of hedge funds (FoFs) and hedge fund indices.
Fund of funds
The concept behind fund of hedge funds is simple and appealing: an
investment manager evaluates and researches a large number of hedge
funds and creates a portfolio of between 20 and 40 underlying funds. In
addition to providing diversified exposure to hedge funds, fund of
funds aim to add value by picking superior managers and allocating
capital among the different investment styles.
Fund of funds activity focuses on the following criteria: manager
research, due diligence, strategy allocation and risk management.
Chart 1 shows the historical performance of fund of funds managers as a
group. The three-year and five-year numbers indicate that managers of
FoFs have had an average return of 3–5 per cent per annum and an
attractive return/volatility ratio of approximately 0.8.
Indices
Hedge fund indices are a combination of individual funds
representative of the broader hedge fund universe, which provide
investors with extensive exposure to one or more hedge fund strategies.
Moreover, they serve as a benchmark for evaluation of individual hedge
fund and actively managed FoFs performance.
Numerous hedge fund indices have been created over the past 10 years.
Typically, each index develops its own set of criteria for underlying
hedge funds that are included in their index, and hedge fund indices
usually include more funds than a typical fund of funds would hold in
its portfolio. The most credible and widely used indices include the
HFR, MSCI and CSFB/Tremont hedge fund indices.
Recently, a new breed of hedge fund indices has developed – the
investable hedge fund indices. These indices are comprised of fewer
funds, typically 40–80 “open” or investable funds that meet certain
liquidity conditions.1 While managers of index portfolios employ
quantitative portfolio construction models that seek to closely track
the index performance of the broad hedge fund indices, full replication
is invariably used for portfolios linked to the investable hedge fund
indices.
The CSFB/Tremont Investable Index was at the forefront of this trend.
This investable index includes only funds that are generally open to
investors and have regular liquidity. The investable index is
rules-based and aims to provide the same standards as well established
traditional equity indices. Based on pro-forma and live performance,
the index provides comparable risk/return characteristics of the
CSFB/Tremont broad hedge fund index. It therefore offers investors a
realistic and representative platform by which to gain diversified
hedge fund exposure. Chart 2 lists the historical performance and risk
of the CSFB/Tremont Hedge Fund Index.
Analysis
As in the long-only world, index tracking funds and investable indices
provide investors with alternatives to actively managed fund of hedge
funds in order to obtain diversified hedge fund exposure.
The following analysis examines fund of funds’ historical performance.
This includes performance analysis on FoFs and hedge fund index
data.(2)
Investable indices today have short “live” track records and, as a result, the broader indices are used for the analysis.(3)
The first issue investigated is the persistence in fund of funds
performance. Chart 3 shows the performance of 275 FoFs in the TASS
database from July 1999 to June 2001 against their performance in the
subsequent period, July 2001 to June 2003. The analysis only includes
fund of funds that existed in both time periods. If historical
performance were an indicator of future performance, returns from FoFs
would cluster around an upward sloping line starting from the origin.
The correlation is not statistically different from zero, indicating
the difficulties of using historical performance to project future
returns. As shown, the data suggests there is a less compelling
argument for persistency among fund of funds managers to deliver
consistently “good” performance.
Performance
Historically, the ability of FoFs to outperform the index has not been
consistent. The performance of the CSFB/Tremont Hedge Fund Index is
slightly higher than the average and median fund of funds, but with a
higher degree of volatility. On an absolute and risk adjusted return
basis, 44 per cent and 50 per cent of FoFs managers outperformed the
index, suggesting that over half of the FoF managers considered did not
generate the necessary excess return to justify the level of volatility
in excess of the index. (See Chart 4.)
Difference
The difference between fund of funds and index perform-ance can be
attributed to two main FoF decisions: strategy allocation and fund
selection. One area of focus is the ability of FoFs to add value by
picking superior managers.
A typical multi-strategy FoF will have up to 50 per cent of its
portfolio in high volatility strategies such as long short equity and
global macro, with the remainder in more relative value-oriented
strategies such as event driven and convertible arbitrage. The returns
of the managers in these two groups of strategies are significantly
different due to their low level of volatility.
Furthermore, for example, in the case of long short equity hedge funds,
the dispersion of points is very wide, indicating that the difference
between the “good” and “bad” funds is substantial. The manager
historical returns indicate that superior manager selection offers
great potential, but that the risk of underperformance is also
significant. Fund of hedge funds are faced with the problem that a
significant number of funds are in strategies with high dispersion,
requiring managers to pick the “right” fund.
With the emergence of hedge fund indices, investors have a growing
number of alternative investment options. We believe that hedge fund
investing, based on its gener-ally higher risk adjusted returns
compared to traditional asset classes, will continue to play an
increasingly important role in institutional portfolios. While actively
managed fund of hedge funds today dominate the field of diversified
hedge fund portfolios, indexation increasingly offers a viable
investment alternative.
1 For further information on Investable Index rules and regulations, please refer to www.hedgeindex.com
2 In our analysis we are mindful of the fact that, unlike fund of fund
returns, hedge fund indices exhibit survivorship bias. In our opinion
the methodology used for constructing the CSFB/Tremont Index
significantly decreases the bias. Please note that due to the
significant lag in the reporting of FoFs performance, the data in this
article is as of June 30, 2003.
3 The CSFB/Tremont Hedge Fund Index, a rule-based asset-weighted index of hedge funds is used for the analysis.
Oliver Schupp, president, Credit Suisse First Boston Tremont Index