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Aon Retirement and Investment Blog

Hedge Fund Indices as Benchmarks

Executive Summary

  • Where clients are looking to benchmark hedge fund investments against a relevant market, or peer average, we recommend that clients use HFRI Fund Weighted Indices as opposed to indices from other providers or the newer Asset Weighted indices from HFRI.
  • In some situations it will be appropriate for clients to use other indices or benchmarking methods. The most common of these that we foresee is investments in CTA or trend-following managers, where HFRI do not publish an index specifically targeting this strategy. In this case we recommend clients use the SocGen CTA Trend Indices, the most widely known provider of indices for this strategy.
  • It is important to note there is no perfect hedge fund benchmark since none of the peer averages are both truly comprehensive and investable.
Introduction to Hedge Fund Indices as Benchmarks
When analysing hedge funds (unlike traditional investment strategies), there are not widely accepted security level benchmarks such as the MSCI All Countries World Index and JPMorgan Global Bond Indices.1 This, along with the fact that two hedge fund managers that call themselves Global Macro funds (for instance) may have vastly differing investment styles, makes benchmarking hedge funds notoriously tricky.

Over time, it has become conventional for hedge fund indices to take the form of peer group benchmarks. This means that they are composed of the returns of underlying hedge funds rather than individual securities (such as in MSCI ACWI or JPMorgan GBI1 ). Generally these indices are weighted in two different ways – equal weighted (also called fund weighted), and asset weighted, where the constituents are weighted according to their assets under management (weight­fund  = asset­fund / assetindex). There are many providers of hedge fund indices in the marketplace today, and the next section will discuss some of them and Aon’s preferences.

Which providers are in the market?
The list of providers  is a lengthy one; some of the more well-known names include BarclayHedge, Credit Suisse Hedge Index, Eurekahedge, HedgeFund Intelligence (HFI), HFN Indices, Hedge Fund Research (HFR), Morningstar, and Societe General (formerly Newedge).2

Using various criteria we can narrow down the list to just a few providers that would be suitable for Aon and our clients. Some of the key issues that we come across within indices include the following:
  • Declining numbers of funds reporting to these databases: some providers have reported the number of funds dropping to as low as 300 for the main composite
  • Unwilling to provide transparency in to which funds are included in the indices
  • Having no minimum asset size or track record length for a fund to be included
  • Too specific – publishing indices only for specific strategies
  • Backfill bias – when a fund is added to an index for the first time, including the fund’s previous performance in the calculations of the historical index performance
  • Survivorship bias – removing funds from calculations of historical fund performance if they become obsolete or stop reporting data
Taking all of this in to account, Aon’s preferred index provider is HFR which addresses all of the issues mentioned above. As noted on the HFR website , HFR is also widely considered to be the ‘go to’ provider of hedge fund index data.

HFR take appropriate measures to avoid both survivorship bias and backfill bias as much as possible. For instance to try and limit survivorship bias, when a fund is removed from the index (either because of liquidation, manager requested removal, or not satisfying criteria for constituency) then the past performance will always remain in the index up until the point of removal. Similarly for trying to avoid backfill bias, new funds added to an index will not affect the finalised past performance numbers of said index. More details on this are available in the endnotes.3

The major fund weighted HFR Indices (HFRI) have been published with historical data back to 1990, with more recent additions to the index line-up including data back to 2008. There are currently over 2,200 unique asset managers providing data to HFR for inclusion in these indices. The criteria for inclusion in the HFRI Indices is reporting monthly net performance to HFR, and having either $50 million in AUM or a 12-month track record.4

There are 1,932 funds included in the broad HFRI Fund Weighted Composite Index, totalling $820 billion under management. The Composite index is then subdivided by four main strategies: Equity Hedge ($210 billion), Event-Driven ($82 billion), Macro ($324 billion), and Relative Value ($204 billion). Within each of these categories there are more granular sub-strategies.

HFRI Fund Weighted vs. HFRI Asset Weighted
Beginning in January 2016 the main HFRI Indices (composite and four strategies) have been published in both an equal (fund) weighted (FW), and asset weighted (AW) version. Historically the indices have been FW, dating back to January 1990, but the new AW methodology (same constituents, dating back to 2008) warrants a look at the differences between the two, and which set might perhaps be suitable for use by us and our clients.

As a business, we have used the HFRI Fund Weighted Composite Index and its various sub-strategy indices for a number of years now. Some of the reasons why include the fact that AW indices from HFR did not exist, as well as the fact that some of the providers listed above either did not exist or had much smaller numbers of funds reporting to their databases.

Performance Comparisons
Looking at return streams of the AW indices in comparison to their respective FW indices, we see that in general they track fairly closely (as would be expected for managers running similar strategies). See charts below for the Composite indices (sub-strategies shown in appendix).

In general, when looking at the cumulative return differential we see that the AW indices steadily outperform over the last three to five years, with a sharp reversal in 2016 where FW indices significantly outperformed AW. This relatively large differential in 2016 was part of the motivation for this study; typically the more well-known managers in the universe are the ones with the larger asset bases, and there was significant dispersion witnessed by industry participants between these managers and the related FW index numbers.

In terms of correlation between the FW and AW indices, over the period from January 2008 – December 2016 the correlation between the Composite Indices was 0.93. Similarly for each of the sub-strategy indices the correlation remained above 0.90 with the exception of Macro at 0.86. This further demonstrates the high level of similarity between the performance numbers.

Index Composition
In this section we will look at the composition of the indices by size of underlying funds, and consider how this could impact the results of FW and AW indices.

In the FW indices each fund has the weight of 1/n, where n is the number of funds in the index. Whilst in the AW indices each fund’s weight is asset­fund / assetindex.

In the case of the AW Composite Index, 50% of the assets are held in only 57 funds out of a total of 1,932, demonstrating the huge weight given to the behemoth funds in the broad index. The figures for the sub-strategy indices tell the same story:

This large skew towards the very large funds in the AW indices means that although theoretically the AW indices could be more representative of the ‘Blue-Chip’ universe that market participants have typically monitored, they will be unduly influenced by the performance of a small number of funds.

Other Considerations
In addition to the two main considerations above, there are other issues to take in to account. For instance, the AW indices are only published for the Composite and main sub-strategy indices. If we were to use a more specific sub-strategy index (for instance the HFRI Relative Value: Fixed Income – Asset Backed, for a structured credit specialist), we would only be able to use an FW index. For this reason we prefer to use FW indices for all in order to retain consistency.

In summary, our analysis indicates a preference for continuing to use the HFRI Fund Weighted Indices because of the following:
  • Minimal return differences and high correlation over time between AW and FW
  • Potential undue influence of mega-funds in the AW indices
  • Maintaining consistency across more specific sub-strategy indices that only have FW indices
  • Continuing to use the methodology that Aon Hewitt has used historically
Finally, it is important to note that there is no perfect hedge fund benchmark since none of the peer averages are truly fully comprehensive and also investable6; and as the index universe continues to evolve we will periodically review our preferred benchmarks.

Refer to this link for index descriptions.

2 This should not be considered an exhaustive list of hedge fund index providers; others do exist in the market.
3 From https://www.hedgefundresearch.com/sites/default/files/pdf/HFRI_formulaic_methodology.pdf

When is a fund removed from the HFRI or HFRX Indices and how is survivorship bias taken into consideration? 
A fund will be removed from an Index when: 
  • It liquidates, or
  • The fund manager requests removal from the Database, or
  • It fails to satisfy the requirements for constituency (as outlined in Methodology section above) 
However, a fund's past performance will always remain in its respective index up until the point of liquidation or manager-requested removal from HFR Database. In an effort to limit survivorship bias, HFR exhausts all efforts to receive a fund's performance until the point of final liquidation. This convention provides the most robust characterization of results possible. Likewise, when a new fund is added to either Index, the historical performance of the new constituent fund will not affect the finalized historical performance of either index. And while the HFRX are finalized upon the date reported, the HFRI are subject to revisions for the trailing four months, although index results are unlikely to be meaningfully impacted by submissions later than 30 days from the end of the performance month. If a non-liquidated fund does not report to HFR Database for three consecutive months, the fund is subject to removal from the HFRI. 

4 Source:  Hedge Fund Research, Inc. www.hedgefundresearch.com

Figures derived from calculations on data downloaded from HFR Database. www.hfrdatabase.com

6 There are a number of hedge fund peer indices that could be considered investable, such as the HFRX published by HFR, Inc. and accessible through a product offered by HFR Asset Management, LLC that tracks the index. However the HFRX indices contain approximately 250 funds, of which approximately 40 are in the HFRX Global Hedge Fund Index.

The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs. Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal, tax or investment advice. Please consult with your independent professional for any such advice. The information contained within this blog is given as of the date indicated and does not intend to give information as of any other date. The delivery at any time shall not, under any circumstances, create any implication that there has been a change in the information since the date of publication, or any obligation to update or provide amendments after the original publication date. The blog content is intended for professional investors only.

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