When evaluating hedge fund performance, a quality index can serve as a meaningful benchmark. The index you choose may help determine your overall asset allocation or be the difference between investing in or redeeming from a manager. But quality indexes have historically been few and far between, leaving allocators with a very limited and often misleading visibility into the returns different managers are able to generate.
Let's illustrate with a quick example. When you are looking to buy a car, you probably review several high-profile websites that contain listings of available makes and models that fit your search criteria. But what if these websites each omitted a significant portion of the total car market? And what if your limited data sample was itself not accurate and complete in terms of price and availability? And lastly, imagine if each website presented its information as comprehensive and accurate.
Would you buy a car based on flawed data? Unfortunately, this is a daily experience for institutional investors, and hedge fund allocators in particular.
Historically, the only thing an asset owner could do to address these shortcomings was to build indexes or peer group benchmarks themselves. That requires substantial resources and technical knowhow. Other than a few sovereign wealth funds and large pension plans, few have even tried. Additionally, even with the best intentions, internal indexes lack independence and incorporate biases of their own.
So, how can an investor determine whether an index is high quality and serves as a meaningful benchmark? Based on our experience, it comes down to four questions:
- What are the data that go into it?
- What is the methodology used to construct it?
- How is the information presented?
- Is there more to the index than just the average?