AMHERST, Mass. (HedgeWorld.com)–Variation across major hedge fund indexes, one of the often-criticized weaknesses of these measures, might not necessarily be a barrier to their use in monitoring hedge fund portfolios and making asset allocation decisions.
Several indexes exhibit similar reactions to stock and bond markets in spite of differences between them, according to research by Thomas Schneeweis and Hossein Kazemi, both from the Isenberg School of Management of the University of Massachusetts in Amherst. For example, hedge fund indices correlate similarly with the S&P 500 and with the Lehman Aggregate bond index, they found.
“In short, despite the return differences, each of the reporting indices generally has the same risk sensitivities to market factors,” Messrs. Schneeweis and Kazemi write in an article titled “Manager Based Hedge Fund Indices: Do They Really Differ and Does It Matter?” prepared for the Center for International Securities and Derivative Markets.
In view of these comparable responses, indexes should be highly correlated with each other in most market environments, they argue. CSFB/Tremont, HFR, MSCI, Zurich and S&P hedge fund indexes are among the data analyzed in this study.
However, the measures are constructed differently and give different average returns. For use in asset allocation, Messrs. Schneeweis and Kazemi recommend adjusting index returns for risk. But they caution that an index should be used for this purpose only if it reflects the investor’s portfolio and when used as benchmark for a strategy it should be style pure.
They suggest thinking of hedge fund returns as a combination of manager skill and the performance of the relevant strategy, given the significant impact of market factors. “As a result, similar to the equity markets, active manager based hedge fund indices can be created which capture the underlying return to the strategy and the performance of individual managers can be measured relative to that ‘strategy’ return,” they conclude.