Don't Buy Into Standard & Poor's New Alternative

Venerable stock index creator Standard & Poor's wants to get in on the explosive growth in alternative investments.

Like a plethora of other asset managers and investment-rating services, S&P is taking a shot at developing a hedge fund index that would be as widely accepted as its stock index. Several firms have attempted this, but so far, few have been met with overwhelming acceptance.

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The proposed Standard & Poor's index, which will unveil its individual components at the end of June, will consist of 40 hedge funds. The funds will be divided into the following nine specific categories: long/short equity, market-neutral equity; managed futures; distressed securities, merger arbitrage, convertible bond arbitrage, fixed-income arbitrage, event-driven special situations, and global macro strategies.

A Different Game

While the anticipated index may appear diverse, it actually includes fewer than 1% of all "known" hedge funds. Many other unknown hedge funds certainly exist, but in a highly unregulated industry that requires little along the lines of registration and compliance, it's hard to track what's really out there.
In comparison, the S&P 500 index tracks about 10% of all publicly traded stocks, which lends itself to far greater sampling and representation of the equity realm than the upcoming index will for hedge funds. Additionally, the S&P 500's segregation of industry types covers a vast gamut of stocks in the universe and accounts for the majority of external factors that would impact equity movement.
Not so for the hedge fund index. With so many strategies in existence, no 40-fund index could possibly represent the goings-on of the alternative universe.

While the emergence of the S&P and other hedge fund indices gives credence to hedge funds' rapid rise in popularity, it also smacks of irony. The very purpose of hedge funds is to provide investment opportunities that are uncorrelated to traditional investments. By attempting to provide venues for passively indexing hedge funds, S&P is trying to turn the alternative-investments industry into just another traditional portfolio component that can be financially engineered and mimicked across the land.

It's an intriguing idea, but it won't work.

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