Indexers find their own bull market - 03/27/01

Hedge fund indices are nothing new. Credit Suisse First Boston and Tremont Advisors launched the first in August of 1999. But suddenly everyone wants to get into the game.

Last week Zurich Capital Markets, a subsidiary of Zurich Fianncial Services, launched half a dozen hedge fund indices along with related investable products; Morgan Stanley Capital International is working on an index; Mount Lucas Management, a futures management firm, has recently launched its own investable index; and AQR Capital Management, a quantitatively based hedge fund, has teamed up with some Harvard professors to offer a risk arbitrage index.

The reasons for this interest stem from the bear market in stocks. Hedge funds outperformed most long stock portfolios last year, with the result that suddenly, big and small investors alike are interested in them.

"What we want to offer is uncorrelated returns without manager selection or concentration risk for institutional investors," said Robert Sloan, a managing director at Credit Suisse First Boston Tremont Index.

But the indexers are faced with several obstacles. The hedge fund world is not very transparent. Institutional investors often cannot be sure what funds will invest in or what risks they will incur. Outsized fund performance is almost invariably gained by taking outsized risks.

Nor is it easy to measure how funds are performing. The Standard & Poor's 500 Index or Lehman Brothers Aggregate Bond Index are seldom good benchmarks against which to measure hedge fund performance even if they do represent the opportunity cost or benefit of investing in non?traditional markets.

And investing in individual hedge funds is expensive. Hedge fund managers usually charge a 1-2 per cent management fee and 20 per cent of performance. Fund of funds managers offer investors the opportunity to make a diversified bet on hedge funds, but they also charge hefty fees.

Indices, if they work correctly, could theoretically form the basis to offer institutional investors low?cost, possibly guaranteed, investable products. They might also provide a hedge for real hedge fund holdings and a benchmark against which institutional investors can measure their individual managers.

But in an industry based on the premise that talented individuals can provide spectacular investment returns, the idea that hedge fund returns can be made systematic is almost blasphemous.

And for the indices to be useful they have to mean something. The devil is in the data in hedge fund indexing. Most indices are formed from an amalgamation of different hedge funds' performance.

Most of them are based on one of the few hedge fund databases. There are fewer than 10 databases, and market professionals consider only half of them truly reliable. CSFB's indices rely on the TASS database, while Zurich announced last Friday the purchase of the Managed Accounts Report database. Zurich has asked Ernst & Young to scrub the MAR data before it can be used as the basis for the company?s products.

"One of the biggest problems in this industry is the reliability of the data," said Garry Crowder managing director at Zurich Capital Markets, adding that he expects the database to he useful for the firm's indices once it has been verified. Usually the databases are based on managers' statements about their own performance, which can be problematic unless they can be checked against investor figures. Compilation problems are exacerbated by the fact that most hedge fund complexes involve several onshore and offshore funds, and databases may ask for figures net of fees or gross.

Not all the indices work that way. Mount Lucas Asset Management's index does not rely on individual manager reporting. It aims to mimic hedge fund performance through a complex mix of strategies in the currency, fixed income and equities markets. But it still relies on data. Mount Lucas had to accumulate performance data before it figured out how to replicate hedge funds.

If the equity and bond markets are a good guide, some hedge fund indices will likely languish, while one major index and a few sub?indices go on to become the widely recognised standard. But despite the risks, there could well be new entrants to the field in the weeks and months to come.

These indices, if they work, could spawn a host of spin?off business. Lehman Brothers' bond business is heavily underpinned by the success of its Aggregate Index. Already Zurich is offering investable benchmarks. Similarly, CSFB has offered structured products on its indices.

At a time when Wall Street is searching hard for ways to make money, hedge fund indices represent one of the few good bets.
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