Managing indices tracking the hedge fund industries

By: brain strom

There may be a number of indices that may be helpful in tracking the hedge fund industry. Basically we can group these indices into two common types, investable and non-investable. There are also a few of other products like the clone indices a product launched by Goldman Sachs and Merrill Lynch, that aims to replicate the returns of hedge fund indices and that too without actually holding any hedge funds at all. When we speak of Investable indices, they were created from funds that can actually be bought or sold. So any hedge fund that would agree to accept investments on the terms that are acceptable to the constructor of the index would be included in these indices. These indices are indexed on the basis of investability which acts as an attractive property as it makes the index more relevant to choices available to investors in practice.

But such indices do not at any point represent an entire universe of hedge funds and may also under-represent the more successful managers, who may at any point not find the index terms attractive. The provider of the index may select funds and develop products to deliver the performance of the index. In comparison to Investable, Non-investable benchmarks may turn out to be more indicative in nature and aiming to represent the performance of the universe of hedge funds. As no single database would capture all funds leading to significant differences in reported performance between different databases. Such indices inherit database in terms of scope and quality of the database. Funds participation may be voluntary leading to self-selection bias. Like is some do not report due to their poor performance or because they have already reached their target size and do not wish to raise further money leading to a clustering of returns around the mean rather than representing the full diversity existing in hedge fund universe.

The short lifetimes of many hedge funds may be due to many new entrants and departures each year leading to the problem of survivorship. And examining the only survival list would overestimate any past returns due to worst performing performers in the past. Whenever a new fund is added to the database then a part of its historical data is added to the record and posted in the index database. As there is also a possibility that the funds may only publish their result when they are favorable, so that an average performance is displayed by the funds during its incubation period. Thus in a traditional equity investment, indices play a central role as they are widely accepted as representatives of the funds and products to provide a liquid access to them in the developed markets. But when speaking of hedge funds no index combines all the characteristics so neither may be wholly satisfactory.

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