CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

38.11 HEDGE FUND INDICES

In the universe of traditional assets, indexing has long been an ideal method of achieving broad-based, low-cost passive exposure to global equity and bond markets. As a result, there are countless investment vehicles based on the idea of tracking broad market indices, many of them with large assets under management. Until recently, indexing has not been applied to the world of hedge funds, since hedge funds were historically marketed as following predominantly alpha-oriented strategies (i.e., a rationale of absolute returns). It is only with increasing demand for hedge funds from institutional investors that the thinking has progressively shifted from alpha generation to beta exposure (i.e., a rationale of risk diversification). Not surprisingly, this shift has also generated a greater focus on how to capture the so-called hedge fund beta through indexation and passive strategies.

Liew (2003) argues the case against hedge fund index investing. First, he shows that aggregate hedge fund index exposure is unwarranted, since only one-third of hedge funds have statistically significant skills when employing a single-factor summed beta capital asset pricing model (CAPM). Next, he presents evidence to show that diversification benefits of hedge fund indices disappear in extreme market conditions. Finally, simulations reveal that with even a reasonable degree of discernment, a portfolio of hedge funds can be constructed to outperform most hedge fund indices.