Alternative investments such as hedge funds have, until recently, resisted indexation. Unlike stocks or bonds, they are not liquid, tradeable assets with easy-to-find prices. Hedge funds come and go rapidly, are extremely secretive, and their portfolios change as fast as their managers’ market views. What funds to include in an index, how to weight them, and when to pull them out are questions fiercely debated among those institutions—Standard & Poor’s, Credit Suisse First Boston Tremont, and Van Hedge Fund Advisors among them—that publish hedge fund indexes and investable versions of those indices.

The inherent problems with direct investing in hedge funds are well documented. Picking winning portfolio managers is as difficult—and likely—as winning an on-the-nose bet at Belmont, and the most successful funds often turn hopeful investors away at the gate. These problems have spurred the popularity of funds of funds.

But funds of funds are expensive—and their cost structure can do more than nibble at the edges of returns. Typically, a high net-worth investor will pay under 1 percent for advice on which funds of funds to embrace. A funds of funds manager may pile on an additional 2.5 percent. Individual fund managers then extract, on average, a 2 percent fixed fee (based on assets) and 20 percent performance fee (based on returns).

PICKING WINNERS Successful hedge fund managers, like winning Thoroughbreds, are exceedingly rare. But you can’t win at the races by betting the whole field. Why try it with your investments? Diversification reduces the chance you will bet it all on a nag.

The index-linked products seek to dramatically reduce these costs, leaving more returns in investors’ pockets. For example, the Rydex SPhinX fund, from Rydex, a Rockville, Md., mutual fund company, is based on the S&P Hedge Fund Index. Here the gates are virtually wide open: The ante is a mere $25,000 (compared with the $5 million minimum typical of hedge funds), and to qualify, investors need only demonstrate a net worth of $1 million and an annual income of more than $200,000. Its fees are more like those of a mutual fund than those of a hedge fund or fund of funds: Rydex SPhinX charges only 1.95 percent of assets.

Backers also say the index-linked products, such as those available in the stock markets, give broad exposure to the sector, eliminating the need to "pick winners." "An index of hedge funds comes down to the general point of any index product," says Neil Aslin, president of Chicago-based Peregrine Financial, a trading and investment firm. "Do you want to invest in the forest or specific trees? The data shows that with any asset class, a strategy of investing in the forest rather than trying to pick the best performers works best."

Others disagree: "Does it make sense to buy a tracking product in the hedge fund sector?" asks Jacob Schmidt, adjunct professor of investments at Webster University’s London campus and director of global hedge fund rating and research at Allenbridge Hedgeinfo, a U.K.-based fund management performance monitoring firm. "They are vehicles that have an alpha—an ability to outperform," he notes. "What is the logic of buying a beta [an average] of that alpha? You may be minimizing your risk but you receive an average return in exchange, not an outstanding return."

Investors to whom this lower-risk and lower-average-return strategy appeals still have to pick the right index—no simple task. The index providers differ in important ways. Oliver Schupp, president of Credit Suisse First Boston Tremont, an index provider affiliated with investment bank Credit Suisse First Boston in New York, says: "The main requirement must be an accurate representation of the [hedge fund] universe and objective index construction." By objective, Schupp means the rules for choosing the index’s funds should not be open to meddling.

CSFB Tremont’s 60-fund investable index is drawn from 448 funds in the company’s broader index. Those select few to qualify for the elite investable index must fulfill liquidity and disclosure requirements. The index encompasses the six largest funds that meet the requirements in each of 10 subsectors (such as long/short equity, convertible arbitrage, and event driven). At launch on August 1, the 60 funds boasted a total of $55 billion in assets, making them, collectively, the largest investable hedge fund index on the market. (The S&P investable index, launched in September 2002, by comparison, comprises 40 funds drawn from nine sectors.) (Click chart thumbnail to view)

The composition of indices, like that of a poorly cellared Bordeaux, can change over time. The rise or fall in popularity of an individual hedge fund investing style directly affects its weighting in CSFB Tremont’s index. "The hedge fund index is an asset weighted index and is determined by the assets under management of each respective fund," explains Schupp. "If, for example, the convertible arbitrage sector gets a large inflow over time, the relative weight of that sector will increase in the index."

S&P takes a different approach: It gives equal weight to the nine investment styles in its investable index, arguing that this "avoids overrepresentation of currently popular strategies." Investors need to decide for themselves which approach makes sense. Those who want to let the market decide how their assets are allocated—for example, if everyone likes emerging markets this month, the index will become more heavily weighted with emerging-market hedge funds—should prefer CSFB Tremont’s approach. Those who want a steady allocation among different investing styles, despite the fact that it will keep them equally exposed to both popular and unpopular styles, might prefer S&P’s approach.

MAN OR MACHINE? Should the choice of funds included in an index be left to an expert’s judgment or be based on strict rules, implemented objectively? It depends: How much do you trust the expert’s judgment? How well written are the rules?

"The aim for [our] product is to be as clearly defined as an [exchange traded fund] on the Nasdaq," Schupp says. "This is not like some index-based products, which have an index committee that makes subjective decisions." But one of CSFB Tremont’s biggest competitors—S&P—selects its hedge funds by committee. Where CSFB Tremont considers a fund’s size (after minimum disclosure and liquidity requirements are met) the key factor, S&P’s index committee attempts to identify managers who best represent their investment style, that is, who don’t drift from one style to another. Critics say this approach means the index is essentially a fund of funds, but without the active management offered by those investments.

Critics such as Webster University’s Schmidt also worry that only the biggest—and least nimble—funds can absorb the type of inflows these index products require. Size and strength do not necessarily equate: Larger funds can be more stable and professionally run, but they may prove too unwieldy to exploit market opportunities, and so risk underperforming smaller competitors. George Shinn, vice president, operations at TraderSource, a Portland, Ore.-based firm that offers alternative investment advice, explains, "Typically the best performance comes from younger, more nimble funds. Once a fund gets to a certain size, it becomes difficult to maintain the same returns."

Finally, investors need to remember to ask the most important question: How do I get my money out? "If the index product has higher liquidity than the funds which it includes, investors may be charged for that privilege [of liquidation]—often up to 5 percent of asset value," says Schmidt. "The only alternative would be if there is an active market in the index product with a buyer available for every seller. That is unlikely." Ultimately, how much do issues such as disclosure and the liquidity of underlying funds matter to the individual investor? As Thane Stenner, international wealth adviser and author of True Wealth: An Expert Guide, points out, all hedge fund products suffer from these tribulations.

"The diversification automatically built into this type of structure significantly reduces the risks inherent on the liquidity issue, as well as the lack of transparency caused by the ‘blind pool’ structure [of hedge funds in the index; a blind pool means the hedge fund manager has total discretion in deciding how to invest]—while of course muting the returns somewhat along the way," says Stenner.

To be sure, it is vital to understand what the product you are buying represents. But an index-linked product should reduce risk through diversification, while significantly reducing costs. As Schmidt notes, many of these issues are only of interest to academics and professionals. He says: "For high net-worth investors, the crucial factor is performance."

From Your Side of the Table: Essential questions to ask your adviser about hedge fund index-linked products.

 What are the constituents of this index and why?
Why funds are selected and removed from the index could have significant consequences for performance. Not all indices include all hedge fund investment styles.

 Is the index rule-based or decided by committee? 
If the former, is its weighting going to remain representative of all types of hedge funds or simply track popular strategies?
If the latter, how is the committee chosen? What are its guidelines?

 How does the product meet redemptions?
What will happen if many investors try to sell at once? Where will the money to fulfill these redemptions come from?

 How does the product track the index?
Does it invest directly in the index’s hedge funds or does it work like an exchange- traded fund and track the index? What are the advantages and drawbacks of the approach it uses?

 Who does the due diligence on the funds in the index?
What experience do the index providers have in the hedge fund industry? What research is done on the funds—and the principals of the funds—in the index? How often are they reviewed?

 How strict is the index?
Ask how long funds have had to be in existence before they can be considered for an index. Ask your adviser what happens to a fund in the index that fails to supply information when it is requested.