Mirroring the growth of the hedge fund industry, hedge fund indexing has taken off in recent years, driven by investor demand for transparent benchmarks and the index providers’ recognition that trusted indexes can, if carefully constructed and marketed, attract their own assets.

By one count as many as 17 separate hedge fund indexes now claim to track the performance of the hedge fund universe. Although these indexes purport to be measuring the same industry, they occasionally vary so widely that getting a handle on what the numbers actually mean can leave investors scratching their heads. Take May and June, for example. Composite returns for five indexes–the Van Global Hedge Fund Index, the Credit Suisse First Boston/Tremont Hedge Fund Index, the Hennessee Group hedge fund index, the MSCI hedge fund index, and the Standard & Poor’s hedge fund index–were within 70 basis points of each other for June.

A month earlier, though, the variation between those same five indexes was 130 basis points. The variations in returns extended below the composite and into the substrategy returns.

The differences highlight what a report from the Edhec Business School in Nice, France, calls “the challenge of representativity.” In other words, you can say you have an index, but its value depends on how well it represents the performance of the industry as a whole. The limitations to representativity begin with the number of funds on which the index is based–which according to Edhec ranges from a claim of 3,100 by HedgeFund.net to 41 by S&P–and extend to include the notable fact that the hedge funds comprising the indexes report their performance voluntarily.

Yet for all their discrepancies in returns, construction, size, and inclusiveness, the indexes themselves seem to have been accepted for what they are: a series of benchmarks that, collectively, can be used to measure the relative performance of absolute return strategies. Additionally, investors, particularly institutional investors like pension funds, love index investing.

That’s one reason why assets linked to the four largest hedge fund index providers–CSFB/Tremont, MSCI, S&P, and Chicago-based Hedge Fund Research Inc.–totaled about $10.5 billion as of March. By one estimate, total assets linked to investable hedge fund indexes as of March ranged from $11.5 billion to $12 billion, up from between $8 billion to $10 billion eight months earlier.

Jacqueline Meziani, a senior director at S&P, explains that its goal “is to represent the range of alpha-generating strategies out there in the hedge fund space.” S&P does that by looking at 41 hedge funds in nine equally weighted sectors. It’s the fewest number of funds included in any hedge fund index, but Meziani says it’s not the number of funds that matters, rather it’s the funds themselves.

Having fewer funds in its index doesn’t bother S&P at all. “It’s like the Wilshire 5000 versus the S&P 500,” Meziani says. “You can include every stock out there, but it’s not really very efficient and it’s really not necessary. Including all the fringe elements doesn’t really add much, and at some point there are diminishing returns from including everything. It’s the same with the S&P hedge fund index. Is 60 funds versus 40 funds more representative? Not necessarily. We’re trying to balance the need to be representative by making sure we have enough funds [while also] making it investable.”–Jeff Joseph and Chris Clair

Chris Clair is a Senior Financial Correspondent at Hedgeworld; Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com), a global provider of hedge fund information and investment products.

Have a question about hedge funds? Feel free to contact Jeff Joseph at jjoseph@rydexfunds.com.

For inquiries about HedgeWorld’s services, e-mail inquiry@hedgeworld.com.