New Year: Growth in Index Funds Anticipated

This is the first in a series examining what's ahead in 2004, from the viewpoints of several industry experts.

NEW YORK (HedgeWorld.com)--Large-scale institutional allocation to hedge fund indexes is among the developments industry people expect in 2004.

This is part of an ongoing growth trend, but investable indexes may offer a solution to difficulties institutions face in making hedge fund investments. For instance, many pensions, insurance companies and other organizations lack experience in this market. Accessing it via an investable index is a lot easier than picking individual managers.

During the past couple of years, several firms introduced such indexes, including Standard and Poor's, Morgan Stanley Capital International, Credit Suisse First Boston/Tremont* and Hedge Fund Research. Typically an index has separate accounts with managers, providing transparency and liquidity.

"Volume is picking up very quickly," said Bruce Lipnick of Asset Alliance. "There is demand from institutions that don't have the infrastructure to look at hedge funds but are familiar with indexing--they already have trillions of dollars in various indexes." Boards understand passive investing, and now that index platforms have become available, they can apply that idea to hedge funds.

Asset Alliance has filed a registration statement with the Securities and Exchange Commission for an index fund based on futures managers .

Other Advantages

There are reports that some index operators are starting to raise a lot of money.

"We think in next six months to a year, you'll see dramatic increases in allocations through that market," Mr. Lipnick said.

Institutions are likely to be particularly concerned about pricing of hedge fund portfolios after complaints on that score at multi-billion dollar manager Clinton Group. Index funds, however, are better protected against valuation problems--in many cases an independent third party prices the separate account.

Another issue is that many hedge funds would be overwhelmed by a single allocation from a large institution, which can run to US$100 million a clip. When that amount is put into an index, it is spread among scores of managers. Again, the index provides a practical solution for the institution.

But diversification necessarily dilutes index returns. "If they want added alpha, they might combine a fund of funds with a passive index," suggested Mr. Lipnick. "They can blend active management with a passive index, as they do with other asset classes--put the bulk of the money in an index and get some extra alpha via an active fund of funds."

No Slowdown

He expects hedge fund growth to not only continue but to accelerate, especially in view of new regulations opening the way to alternative investments in countries such as Germany. His forecast: Worldwide the industry will double in size over the next five years or so.

Since the stock market slump in 2000, institutions increasingly have become interested in hedge funds. More and more corporate and public pension plans are making these investments. "In spite of the turmoil in every sector of the financial services market, the hedge fund industry has grown," said Mr. Lipnick.

"People want to allocate money to absolute returns once they've been burnt in long-only investment, even after the markets look better," he added. "They are increasing their allocations, whether to 5% or 10%. The mutual fund industry did not produce a positive return for investors for years, whereas hedge funds have."

Asked which strategies he likes for 2004, Mr. Lipnick hedged. Returns on various strategies depend on factors such as on interest rates and the marketplace in general. So he won't commit beyond the timeless maxim, "A well-diversified portfolio should do well."

For his own business of taking stakes with managers and seeding new ones, he predicts unprecedented opportunities. More managers with track records are leaving mutual funds, and many need help setting up a business. "The brain drain is picking up, after going on for two years," said Mr. Lipnick.

That's the next generation of hedge fund managers, who it is hoped will provide the capacity for all those indexes and other investments. Of course, many will not succeed. Mr. Lipnick is philosophical: "In any business, only the quality will rise to the top."

*Tremont Capital Management Inc., Rye, N.Y., is a strategic partner of and a minority investor in HedgeWorld.

CKurdas@HedgeWorld.com

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