Another Alternative -- a Hedge Fund Index

Last Friday's market meltdown has added fuel to the ire of individual investors certain that there must be some alternative.

The venerable Standard & Poors agrees, and wants to provide that new alternative -- albeit to institutions and accredited investors. (An accredited investor must have a net worth of more than $1 million, or have earned more than $200,000 in the past two years with a reasonable expectation that this will continue.)

Last week, the firm announced that it was creating an index of hedge funds. The index is aimed at providing investors with a variety of highly correlated hedge funds that have agreed to greater transparency and can be used as a benchmark. More importantly, S&P also plans to launch a raft of products based on the index.

The 40 hedge funds that will make up the index will not be announced until the end of June, but several in the industry have already voiced skepticism that such an index will even be useful, let alone beneficial.

The index will be structured along three categories of single-strategy funds. Each type will constitute its own sub-index: arbitrage, tactical and event-driven.

Each sub-index will consist of three types of funds. The arbitrage category will include convertible arbitrage, fixed income and equity market-neutral funds. The tactical category will include macro, managed futures and long/short equity funds. And the event-driven category will hold distressed, merger arbitrage and special situation funds.

But with some 6,000 hedge funds in existence, an index of 40 funds representing nine strategies may not accurately reflect the industry, critics say --especially since there's no shortage of more comprehensive indexes. Several firms are vying to provide authoritative and useful information on the industry -- among them are Tremont Advisers, which publishes its own indices through a joint venture with Credit Suisse First Boston; Van Hedge Fund Advisors; the Hennessee Hedge Fund Advisory Group; and Zurich Capital Markets.

"The S&P is going to raise a tremendous amount of money because of their name and the greater transparency they'll provide," said Ben Warwick, chief investment officer of Sovereign Wealth Management and a contributor to RealMoney.com. "But nothing leads me to believe that the index will reflect hedge fund returns overall."

S&P acknowledges that there are areas of the hedge fund industry that won't be reflected in the index, such as funds that use more than one strategy or a particularly unique strategy. But the firm maintains that 30 funds are enough to appropriately reflect the universe of single-strategy hedge funds, and they'll throw in 10 more for good measure, said Peter Roffman, vice president of S&P Portfolio Services. "The index will represent the universe we define," Roffman said. "The hedge fund universe is incredibly diverse, and there are pockets of it no index can track."

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The selection process for the funds entails four stages, incorporating both quantitative and qualitative measurements, Roffman said. First, S&P determined which funds fit the categories S&P selected, and then tracked their correlation. Only funds that showed a high correlation to their peers will be included in the index. Outliers were eliminated.

Next, S&P contacted the funds to assess their willingness to provide greater transparency. Each fund chosen for the index will set up a managed account that will disclose its net asset value (NAV) daily to Derivatives Portfolio Management (DPM), a financial administration firm, which will verify the fund's valuation. DPM will transmit the data to S&P, which will then be able to update the index daily.

S&P enlisted the help of Albourne Partners, a hedge fund consultant in London, to perform due diligence on the funds willing to comply. Lastly, the S&P indexing committee will choose and maintain the final 40.

The index will be equal-weighted, unlike the S&P 500, which grants greater weight to companies with bigger market capitalizations. "I'm surprised they're going that route," said Robert Schulman, chief executive of Tremont Advisers. Schulman compares the CSFB Tremont hedge fund indices to the S&P 500 as an appropriate proxy for a broad swath of the market. "An equal weighted hedge fund index is like the Dow Jones -- and no institution or large investor wants to put their money in just 30 stocks."

But S&P's Roffman said that an equal weighting would eliminate any errors caused by swings in investing trends. "We don't want to chase where the hot money is going," he said. "Just because the long/short area is hot at some point, the rest of the index shouldn't be affected. We want to give people broad and balanced exposure, and the best way to do that is through equal weighting."

Ironically, it is S&P's proudest point -- the increased transparency of a manager's decisions -- that impresses some critics the least. "Top tier managers aren't willing to offer separately managed accounts, and portfolio transparency isn't something they typically negotiate with clients," Warwick said. "I suspect the index will be a compilation of 40 second-tier managers. It won't reflect the best."

Indeed, the whole philosophy of hedge fund investing -- be it for high net-worth individuals or institutions -- is active management. Your investment reflects a belief in a manager's ability to make money under any market conditions.

Hedge funds of hedge funds still employ an active management strategy, in which the fund-of-funds manager generally chooses 10 to 20 funds that will achieve a certain goal. Generally, funds of funds outperform the hedge fund indexes.