Fund-of-Hedge Funds Find Capacity In Investable Indices

Jun 2 2006 | 8:00pm ET

While investable hedge fund indices and fund-of-hedge funds are often pitted against one other when it comes to the pros and cons of each investment strategy, increasingly, fund-of-funds managers are revealing that they too are jumping on the investable index bandwagon.

"We will see more fund-of-funds disclosing that they are investing in these," said Mark Smith, founder and president of Mark Edwards Advisor, LLC, which provides risk management services to alternative investment firms. He believes that one reason this trend is coming to light now is the pressure on hedge fund managers to become more transparent.

"The guys who have been around have a greater amount of leverage [when it comes to transparency]," he said. "The younger guys have to prove themselves."

He also said that with all of the money sloshing around hedge funds these days, capacity has become a huge issue and fund-of-funds are always looking at new strategies to absorb their assets.

"There are fund-of-funds that have 10 managers plus 1-2 investable indices plus a private equity tranche," he said. "Anything that can absorb a good amount of capital with reasonable volatility and some level of transparency and quality will at least be looked at."

Justin Dew, senior hedge fund specialist and director of portfolio services at Standard & Poor's, said that fund-of-funds sometimes invest in an investable hedge fund index as a cash alternative for a short period of time, which is exactly what one New York-based fund-of-funds manager is doing.

"Typically, I hold 5-10% [of assets under management] in cash or indexed funds, which allows flexibility," said the manager, who requested anonymity. He explained that when an underlying manager is removed from one of the firm's portfolios, it takes time to redeploy the money to other funds.

Dew said that another interesting trend that he has been observing is that fund-of-funds managers are making allocations to indices that focus on individual strategies, such as managed futures, in an effort to achieve the beta of the alpha generating strategy.

"The reason I think that a lot of fund-of-funds utilize these strategy [specific] indices is that it gives them quick, relatively inexpensive access to these strategies," Dew said, explaining that otherwise, managers who want exposure to certain areas would have to spend a lot of time and money performing due diligence on potential underlying managers.

Pros & Cons of Investable Indices

As for other investors, there are various pros and cons when it comes to investable indices. Dew said that some of the pros —at least with the S&P's Investable Hedge Fund Index, which represents nine different alpha generating strategies in an equal weighting — are that there is transparency and investors understand the methodology. "It removes a lot of the opaqueness that exists in the funds-of-funds world," he said.

He also said that on a risk adjusted basis, investable hedge fund indices tend to outperform fund-of-funds.

"Given the equal weighting [of the S&P Investable Hedge Fund Index], the resulting portfolio has a very low volatility measure, somewhere in the range of 2.5-3.5%," he said, which is significantly less than in large fund-of-funds where volatility is usually 6- 10%. Meanwhile, both of these figures are much lower than in equity markets, where volatility tends to be in the 11-15% range.

Dew added that some of the cons when it comes to investable hedge fund indices are that sometimes a manager is closed or is unwilling to run a managed account, which is how the S&P investable indices are structured.

As for performance, Dew said that although S&P doesn't track the specific results of funds-of-funds, their performance often depends on the economic climate at the time.

"A lot of times when equities outperform, the likelihood of a fund-of-funds outperforming [an investable index] is higher than in periods when some other type of hedge fund investing takes the lead, call it macro or managed futures," Dew said. "In those instances, a lot of the investable indices will outperform a fund-of-funds."

The Alternative Asset Center reports that its non-investable fund-of-hedge funds index was up 6.75% this year though April, while The Credit Suisse/Tremont Investable Index was up 5.59% this year though April and S&P Hedge Fund Index was up 5.08% during the same period. However, experts caution that indices —both investable and non-investable —vary widely in their composition and methodology and can be difficult to compare.

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