7 - Hedge fund indices: Are they cost-effective alternatives to funds of funds?

Abstract

Investable hedge fund indices have evolved from noninvestable benchmark indices to provide low-cost access to returns correlated with the hedge fund industry as a whole. In addition, subindices designed to represent style-specific hedge fund strategies allow investors, including FOFs and structured product providers, to gain access to specific return patterns generated within the hedge fund universe that may be superior to overall average hedge fund returns under certain market conditions. Some consider investable hedge fund indices to be cost-effective alternatives to funds of funds (FOFs) as means to gain access to “hedge fund beta.” If this view becomes widespread, it is possible that assets may flow from FOFs to these indices. The indices, however, may underperform FOFs. One argument against hedge fund index investing holds that FOF managers skillfully select enough good managers to outperform indices. This study suggests that if one must choose one or a few funds from among the universe of FOFs, the likelihood of outperforming an index is approximately equal to that of underperforming an index. Yet if a large diversified portfolio of FOFs is attainable, it may slightly outperform an index.