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| Feature |
Risk & Reward Retrospective
John Ferry
01/01/2006
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1. Hedge Fund Index-Linked Investments
An Alternate Route Through the Hedge Fund Maze December 2003, page 96.
Investors seeking exposure to the burgeoning alternative investment sector have
poured money into hedge fund index-linked investment products in the last two
years, despite the hedge fund sector’s generally lackluster performance. “The
demand was stronger in 2004, no question, but we still have several hundreds of
millions of inflows into the products,” explains Oliver Schupp, the New
York–based president of CSFB/ Tremont, a hedge fund index and related product
developer. Product providers like CSFB and its rivals are also offering greater
customization—for example, products linked to indices designed to the investor’s
specifications.
THEN AND NOW
These products have increased in both popularity and complexity
since late 2003, with sophisticated banks now offering private clients the
ability to tailor indices to their liking. But there is still debate over how
best to design both the indices and the products themselves, and long-term
performance data remains hard to find. |
The world of hedge fund indices has evolved rapidly since the
first credible performance benchmarks emerged in the late 1990s. Today, a number
of firms, including Standard & Poor’s, Dow Jones, Van Hedge Fund Advisors
and CSFB/Tremont, publish indices. However, these benchmarks remain hamstrung by
the sector’s lack of transparency and debates over the design of the indices
themselves. For example, some index providers use a rules-based system, where
any fund that meets certain criteria is automatically included in the index,
while others rely on the judgment of a committee of experts. Survivorship
bias—which is the positive skew in an index’s performance attributable to the
fact that only the funds that survive remain in the index—also continues to vex
some analysts, and it makes many advisors wary of index-linked
products.
However, one oft-cited criticism of hedge fund index-linked
products—that they mix stars with sluggards, resulting in a tepid average
performance—has been addressed somewhat by the emergence of bespoke indices in
which clients choose their favorite constituent funds.
Schupp believes the
hedge fund indexing business is now mature. The larger question for investors is
why the sector is underperforming as a whole; many think it is a capacity issue.
“A lot of money has been invested in the convertible space the last couple of
years, so there was not a lot of room to make money on the arbitrage side,” says
Tom Whelan, chief executive of Greenwich, Conn.-based Van Hedge Fund Advisors.
Others have a more optimistic take on the problem. Kevin Pilarski, director of
alternative strategies and derivatives at Dow Jones Indexes in Chicago says, “I
think it’s much more of a cyclical issue. Equity volatility has been at 10-year
lows, and credit spreads have also been tight.” If he is right, the strategies
that suffered in 2005 may make a comeback. 2. Inflation-Linked Investment Products
Inflated Optimism February 2004 page 96.
The largest jump in the consumer price index in 25 years pummeled the markets in
September, but those investors who had taken advantage of the economy’s
decade-plus hiatus from inflation to hedge their portfolios against just such a
development could breathe a bit easier than most. With the threat of
inflation—and worrying comments from members of the Federal Reserve about the
need to raise short-term rates well north of 5 percent—many traditional
investments may be set to underperform on a real basis, while inflation-linked
products could shine.
 Even so, it has been a mixed year for the main
inflation-hedged investment product, the government’s Treasury Inflation
Protected Securities (TIPS) bonds. TIPS have a payoff that rises in line with
the Consumer Price Index for Urban Areas (CPI-U), the most common measure of
inflation. TIPS also perform well in a rising interest rate environment.
However, they underperform other government securities when inflation falls or
is stagnant.
Some funds that invest in TIPs are currently showing negative
returns. The three-month cumulative rate of return on financial services company
TIAA-CREF’s Inflation-Linked Bond fund, for example, was –0.04 percent at the
end of September. However, this could be the result of surprisingly low
inflation figures in May and June.
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