What can be said with certainty is that the world has not, in recent years, been faced with so much instability across so many different domains: global health, trade and, most recently, geo-politics, said Darren Wolf, global head of investments for alternative investment strategies at abrdn. “This backdrop typically has led to strong performance for hedge funds on the back of high volatility and significant dispersion across markets.”
Yet as more institutional investors turn to alternatives such as hedge funds, they remain wary for a good reason. “The cost of getting your manager selection wrong is more severe in these types of environments,” Wolf said. “The risk of getting the overall bet right and the execution wrong can be pretty painful.”
That’s where investable hedge-fund indices come in, that provide passive index exposure to hedge funds but without the execution risk.
“Investable hedge-fund indices are very similar to passive equity investing in some ways, but very different in others,” Wolf said. In the case of equities, holding the benchmark delivers passive beta returns and, by definition, it means completely giving up on alpha or outperformance. Hedge-fund benchmarks, in contrast, offer the additional promise of alpha, he noted, as well as diversification and elimination of the selection risk of investing in a single manager. “Passive investing in hedge funds offers very similar benefits to passive equity investing, but with the additional prospect of generating alpha.”
Avoiding the limitations
For investors looking for passive exposure, hedge fund indices have typically been “un-investable,” unlike equity indices where it is easy to buy a basket of securities that make up the index, Wolf explained.
“Hedge funds aren’t a single asset class that shares common risk factors. They’re trading strategies,” Wolf said. They include a range of strategies such as global macro, event-driven, or fixed-income arbitrage funds, each of which have nothing in common except perhaps their regulatory status and the words ‘hedge fund’ in their name. They are hard to access — some are closed to new investors, others are very small and still others are highly illiquid, he said.
Investors and providers sold on the idea of a passive approach to hedge funds have tried get around these challenges through what are known as replication strategies, Wolf said. “Traditional replication strategies involve identifying ‘factors’ that represent hedge-fund returns to try to generate a return stream. It’s more of a synthetic way to attain passive hedge fund exposure,” he noted. However, many hedge-fund returns aren’t explained by risk factors and are not captured by these strategies, and the strategies don’t precisely track many benchmarks and could underperform them since they don’t directly invest in hedge funds.