Issues in Hedge Fund Index Engineering: A Comparison and Demonstration

Abstract

We examine hedge fund index construction methodologies, by describing and analysing the general principles and construction methods for a successful hedge fund index. We present case studies from two well-known database vendors and evaluate them using numerical examples on the same dataset. Despite the fact that they follow a similar due diligence process, there are great differences in the index engineering practices arising from different quantitative techniques, even for indices in the same hedge fund category. However, those quantitative techniques provide similar results. The differences are rather due to the use of different hedge fund universes and different inclusion criteria. This paper is the first to use actual numerical case studies to illustrate and compare how hedge fund index engineering works. Having read it the reader will have a good understanding of how hedge fund indices are formed and current issues in the area.