Advisors looking for alternative investments are likely soon to have an attractive new vehicle: a passively managed fund of hedge funds.

Standard & Poor’s on September 17 launched its Hedge Fund Index (HFI), which comprises 40 hedge funds representing three broad styles and nine different investment strategies.

While other hedge fund indexes have been introduced in recent years, this is the first investable hedge fund index. By mid-year 2003, you’ll see the first of a series of limited partnerships rolled out by PlusFunds, which has been licensed by S&P to create investment products based on the HFI. The first product is likely to be a fund of funds mirroring the S&P HFI index–investing equally in all of the hedge funds selected to participate in the index. Investors will thus be able to access a diversified group of hedge funds.

It can be difficult to get specific information about hedge funds because they are private investments that are not permitted to advertise, but the additional complication on this new product is that nothing has been filed yet with the Securities & Exchange Commission. However, a source familiar with the plans say the new product will have the same quarterly liquidity opportunity as a traditional hedge fund and offer a way into a broadly diversified set of hedge fund styles at a minimum investment of less than $1 million.

Unlike a traditional hedge fund of funds, you won’t have to pay a performance fee to the manager of the index fund. That’s so because the manager will not be trying to pick the best hedge fund managers and strategies, since the fund is passively managed to match the index. There are funds of hedge funds already offered that provide broad diversification with similar minimums, but they typically charge a performance fee that gives them 20% of the profits as well as a management fee. The HFI investment fund should offer a way to avoid the performance fee on the manager of the index fund while providing the benefits of a well-diversified basket of hedge funds. Investors in the HFI fund of funds will still need to pay the performance fees and management fees charged by the underlying hedge funds in the index in addition to the management fee of the index manager.

The S&P HFI is made up of three styles and within each style there are three strategies. Funds that do arbitrage will be represented by five market-neutral stock funds, five fixed-income arbitrage funds, and five convertible arbitrage funds. Funds with event-driven strategies that specialize in corporate takeovers, mergers, and bankruptcy will be represented by three merger arbitrage funds, four funds specializing in distressed securities, and five funds that specialize in other special situations. Tactical or directional funds, which exploit broad market trends in stocks, fixed income, or commodities, will be represented by five hedge funds that use long and short strategies, four funds using managed futures, and four funds exploiting macro trends in markets.

The 40 funds chosen for the index have an average size of about $500 million. While traditional hedge funds have no more than 99 partners, securities lawyers have come up with ways in the last few years of allowing up to 499 investors into a privately placed partnership. A source says that all 40 funds have assured the fund’s sponsor that they can handle at least an additional $100 million in capital, and some of the funds have the back-office strength, investment style, and capacity that will tolerate much greater growth. Additional funds may be added to the index.

The hedge funds participating in the index have agreed to provide unprecedented transparency to Standard and Poor’s in exchange for being included in the index. S&P will publish index values daily based on a daily disclosure of every security holding in every fund. While investors will not see security level data daily, they will see the risk level and currency exposure of the hedge fund index daily.

The 40 funds in the index include some managers who are well known among independent advisors, such as First Quadrant, an institutional money management fund run by Rob Arnott, who is perhaps best known to advisors for his bleak outlook on the equity risk premium, and Merger Fund, managers of an unusual mutual fund popular with advisors that invests in takeover plays. It does not include “stars” of the industry, such as Soros Funds, but does include a number of managers with long-term track records in running hedge funds, such as Clinton Group, which manages $8.8 billion in arbitrage strategies, and Deerfield Capital Management, which runs $7 billion in fixed-income government arbitrage, investment-grade corporate bond, asset-backed securities, and bank loan asset management strategies. A London-based consultant, Albourne Partners Ltd., did due diligence on each manager to assess its style purity, practices, and operations.