Passive trend's new milestone is to track 500 hedge funds

The passive investing wave is coming to hedge funds.

Aberdeen Standard Investments and Hedge Fund Research Inc. are charting new territory by creating a fund that tracks HFR's broad index of 500 hedge funds.

The product will allow wealthy investors and institutions to play in the rarefied world of hedge funds without having to kick their tires or deal with the egos.

"For the first time you can have access to the space without having the internal costs of selecting managers or paying a premium for someone to externally handle that manager-selection alpha for you," said Russell Barlow, global head of alternative strategies at ASI, which oversees about $670 billion. "You can just buy the passive version."

The development is a testament to just how far-reaching index funds have become, touching almost every asset class. And it comes as stock pickers were dealt a big blow Wednesday as assets in U.S. index-based equity mutual funds and exchange-traded funds topped those in active stock funds for the first time in August.

The new ASI-HFR product will allow clients to passively invest in hundreds of actual flagship hedge funds, as opposed to separately managed or liquid alternative versions of them, said HFR founder Joe Nicholas. The fund is expected to start trading in January, along with 30 strategy and substrategy index funds.

The hedge funds in the new, underlying index are being selected for their liquidity — quarterly or better — and size. They are required to report their performance and assets under management monthly to HFR. Investors will be able to subscribe or redeem from the index fund quarterly.

Chilton Investment Co., Mariner Investment Group and Man Group are among the hedge funds in HFR's 500 index, according to Mr. Nicholas.

Investors will need to put up a minimum of $5 million to get into the fund. They'll also pay a fee for the product as well as blended management and performance fees for the underlying hedge funds. Some of these charges are being determined. The index's performance will be net of the hedge fund managers' fees.

The management fee is likely to be a fraction of what fund of funds charge, according to Mr. Barlow. That averages 1.17%, Preqin data show. The HFR's benchmark 500 index fund has an average management fee of 1.4% and the average incentive fee of 17%.

If successful, the index fund could prove another challenge for the beleaguered fund-of-hedge funds industry, which has suffered 11 straight years of net withdrawals. Investors have abandoned these middlemen due to paltry performance and the extra layer of fees they charge. Industry assets totaled $643 billion in June, down from a peak of almost $800 billion in 2007, according to HFR.

The risk for ASI is that the new fund could cannibalize its own hedge fund-of-funds business, but Mr. Barlow thinks it will instead tap into client money sitting on the sidelines.

Investors such as state pensions funds are underallocated to the hedge fund industry by $200 billion in the U.S. and £24 billion ($30 billion) in the U.K., vs. their target allocations, according to ASI's estimates. The index fund is expected to capture some of those players who, due to the constraints associated with hedge fund investing, prefer to invest passively.

"There's an enormous component of allocators to alternatives that are underweight the investment class," Mr. Barlow said. "It boils down to a combination of a lack of liquidity, high fees, transparency and performance."

Active money managers have been bleeding assets in recent years as clients rebelled against high fees and disappointing returns, a trend that prompted Moody's Investors Service to predict that index funds will overtake active management in the U.S. by 2021.

Michael Burry, the hero of Michael Lewis's book "The Big Short," warned last week that passive fund inflows are inflating a new stock and bond bubble that is bound to blow up as money linked to fund indexes exceeds amounts traded in individual stocks.

ASI said its liquidity requirements will help it avoid a mismatch in flows between the new fund and its underlying managers. If an underlying fund ends up shuttering or gating investors, the index will mark the position to the secondary market — in some cases, zero — and remove the fund from the index. Meanwhile, investors will have the option to keep their exposure to the offending fund — even if they redeem from the index product — to not miss out on any future recovery.

In February, ASI started a liquid alternatives index fund that offers daily liquidity and tracks a separate HFR index of about 180 UCITS funds. The European Union's UCITS directive allows such funds to employ some hedge fund techniques, such as using leverage or shorting. They're also more affordable to retail investors than a typical hedge fund.

A handful of other UCITS index funds tracking watered-down versions of hedge fund manager strategies, or with a smaller constituent of funds, have existed at one time or another.