Retail Hedge Fund Index Products Finally Arrive

In the past, we have written about hedge funds (also known as absolute value strategies), and how they might fit into an investor's portfolio (see our June, 2003 and April, 2002 issues). However, until now, we have not included them in our model portfolios because there have been no broadly diversified products available, at a reasonable cost, to most individual investors. The ones which have been on offer, known as "Funds of Funds", are quite expensive: in effect, you often pay quite high fees not only to the hedge fund managers themselves (typically one percent of the assets under management, plus twenty percent of the profits), but also to the Fund of Funds manager (typically a one to three percent management fee, plus, sometimes, a sales load and/or a share of the profits distributed by the underlying hedge funds). A second issue with the Fund of Fund concept is the question of fund selection: in effect, when investing in a Fund of Fund, you are hiring an active manager to hire other active managers. Not only is this an expensive proposition, but in effect, it raises the already daunting challenge of active management to the third power: you have to choose a winning fund of funds manager, who will pick winning hedge fund managers, who will make winning investments. Got it? Comfortable with it? Neither were we. Given the potential risks and returns presented by the Fund of Funds approach, we have not been of the opinion that most Funds of Funds represent a good value for investors.

This situation has now begun to change, with the introduction in Canada of hedge fund index products for individual investors, as well as new tracker funds in Ireland and Jersey. In this article, we will take a closer look at these, and explore their advantages and disadvantages. In January, 2004 we will publish updated model portfolios that include hedge fund index products in their universe of possible investments (next month's end of year issue already has enough numbers in it!).

We'll begin with a critical point, from which other important ones flow. Hedge funds are not an asset class. Asset classes represent some type of claim on real productive assets that share common characteristics. As noted in last month's article on active investment management, the return on an asset within an asset class has two components: compensation for the risk of the asset class itself (also known as "beta risk"), and compensation for risks unique to the specific asset under consideration (also known as "alpha risk"). When you hold a diversified portfolio of assets from within the same asset class, the alpha risks (and the returns associated with holding them) cancel each other out, and you are left with non-diversifiable risk (also known as beta or systemic risk), and the return for holding it. When you diversify your portfolio across asset classes, the beta risk is reduced, but not eliminated.

In contrast to a true asset class, the broad term "hedge funds" refers to a very diverse collection of actively managed investment strategies which aim to maximize the return for holding alpha risk in one or more asset classes. Investing in hedge funds is attractive for two reasons. First, because hedge fund managers seek to maximize alpha, their exposure to beta (or asset class) risk is often minimal (e.g., one could invest in specific shares, and use derivatives to hedge its exposure to overall market movements, leaving the fund with pure company specific alpha risk and return). As a result, hedge fund returns often have very low correlations with the returns earned on index funds which track the returns on different asset classes. Given this, including hedge funds in a portfolio should produce diversification benefits, in the form of a reduced level of overall risk.

Second, there is also an argument to be made that hedge funds should produce higher returns than actively managed mutual funds that invest in the same asset class. Three justifications are typically given to support this argument. First, hedge funds offer much better compensation packages to their managers than do actively managed mutual funds (e.g., twenty percent of the profits). Theoretically, this should attract the best active managers to hedge funds, and provide a strong incentive for them to make the best use of their abilities. Second, hedge funds place far fewer restrictions on the ability of a manager to translate his or her forecasts into portfolio positions. For example, unlike mutual funds, many hedge funds can and do take short positions (i.e., sell a security they do not own in the expectation that its price will go down, and they can later buy it -- or "cover their short" -- at a price lower than the one at which they sold it), and employ leverage (that is, use debt to take on larger positions than they could using just the money investors have contributed to their fund). Finally, while actively managed funds have to keep a portion of their asset in low return cash deposits (to cover any imbalance between daily fund redemptions and sales), hedge funds do not, because their investors cannot withdraw their funds on short notice.

However, there is also an important theoretical disadvantages to investing in a diversified group of hedge funds (either through a Fund of Funds or through an index product). Hedge funds employ active management strategies, which, in aggregate, are a less than zero sum game. As previously noted, in a broadly diversified portfolio, alphas net out, and all that is left are the fees paid to the active managers (in short, all that is left is a very expensive de facto index fund!). This is true for people who invest in a broad range of actively managed mutual funds. And, in theory, it should also be true for people who invest in a wide range of hedge funds, unless hedge funds as a group earn a positive alpha (which, in turn, implies that some other group of active investors is earning a negative alpha). This is the question you must confront before you decide to invest in a broad hedge fund index product.

We'll tell you what we think. Given the extreme difficulty of being a consistently successful active manager, common sense suggests that the best of this group will seek out the opportunities that will offer them the greatest rewards for their skills. That means the best managers are more likely to be found at hedge funds, where the pay is better than at actively managed mutual funds. On balance, this leads us to conclude that higher alphas are likely to be earned by hedge fund than by actively managed mutual fund managers within any given asset class. Moreover, the data show that, to date, the alphas on different hedge fund strategies generally have not cancelled each other out (although this still may happen, as more money flows into hedge fund strategies). On balance, we conclude that if a typical individual investor is going to use active management, the best way to do it is through a hedge fund index vehicle: the cost will be lower than a Fund of Funds, the return will probably be higher than what you would earn on an equivalent allocation to actively managed mutual funds, and it also will probably have a lower correlation with the returns on the asset class index funds already in your portfolio.

Another issue which has concerned us is the specific funds that will be chosen for inclusion in the hedge fund index tracked by the new funds. Two considerations are involved. First, some strategies have more "capacity" than others. This means that some strategies can keep on delivering positive returns even when they receive large inflows of new funds (global macro funds are an example). In contrast, the returns on other strategies can be adversely affected by a large inflow of funds (e.g., distressed debt investing, where fund inflows would result in prices being bid up, which lowers expected returns). Second, even within broad classes of strategies, some funds may have more capacity than others, depending on the specific investment technique they are using.

To address these issues, the companies which produce the various broad hedge fund performance indexes have created subsets of them, which they usually call their "investable" index. These are the indexes which the new hedge fund based index products will attempt to track. What needs to be recognized clearly is that the decision on which hedge funds to include in these investable indexes is, at its core, an active management decision (which, to be accurate, could also be said about the decision to include or remove a company from an index like the S&P 500, which is only a subset of the broader market). Depending on the hedge funds selected, the returns on the investable index may track the overall hedge fund index returns quite closely, or they may diverge from them by a large amount. As these products are quite new, only time will tell.

Now, on to the new products themselves. The first is called the Tremont Hedge Fund Index Linked Trust, which will be traded on the Toronto Stock Exchange. It is designed to track the CSFB/Tremont Investable Hedge Index, which includes sixty different funds, representing the six largest funds in ten different broadly defined investment strategies. As we described in our April, 2002 article, we believe that CSFB/Tremont uses a very good index construction methodology. Moreover, we believe that using the largest hedge funds to construct the investable index should ensure relatively close tracking with the overall CSFB/Tremont hedge fund index, because the latter is asset weighted. To make it more attractive to Canadian investors, this fund will employ a creative structure which will defer income and taxes until 2010. According to its preliminary prospectus, its management fee will be a very reasonable .55% per year, which is well below the fees usually charged by Funds of Funds.

The second offering is from One Financial. It takes the form of a capital guaranteed note, whose return is linked to the performance of the Morgan Stanley Capital International Hedge Invest Index. Like the CSFB/Tremont index, the latter is asset weighted, and utilizes a strong underlying methodology. The actual note (a debt instrument) matures in about ten years, and, as a return, offers the greater of ten percent or 150% of the return on the MSCI Hedge Invest Lyxor Tracker Fund (less a charge for the capital return guarantee). At 1.50%, the underlying expense ratio is higher than the one on the Tremont product. On balance, we prefer the Tremont offering to this one, because of its lower costs and cleaner structure.

Finally, at press time we were still trying to obtain more detailed information about the new MSCI Hedge Invest Lyxor Tracker Fund that has been registered in Ireland and in Jersey by a subsidiary of Societe Generale. However, the message seems to be clear: in 2004 we will no doubt see the launch of many similar products, which we will continue to track and evaluate. In the meantime, we will begin the new year with an alternative set of model portfolios which incorporate allocations to hedge fund index products.