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Wednesday, April 16, 2014

The Answer for Indexing Alts? Maybe a River Runs Through It

Reported by Anastasia Donde

The answer on how to benchmark liquid alternatives might be found by crossing the Chicago River a few times.

Morningstar, which is the bible on mutual fund information, and Hedge Fund Research, which leads the charge on hedge fund benchmarking, are located on opposite sides of the Windy City's river, about a 10-minute walk away from one another.

While most institutional investors and their consultants widely use HFR to benchmark their hedge fund portfolios, Morningstar is most commonly tapped by retail investors and advisors on mutual fund analysis and indexing. However, no one seems to have a good answer yet on how to index alternative mutual funds.

Part of the problem, of course, is that these funds are alternative and, by definition, are esoteric strategies that tend to defy indexing (or wish they could). Alan Brown, a senior adviser and former cio of Schroders, said that "we need to get away from these benchmarking hugging mandates" while touting the firm's multi-asset class portfolios at Schroders' media breakfast last month.

The other problem, though, is that without a benchmark there is no way to hold fund managers accountable.

Another issue is whether to throw like-structures or like-strategies into the same index basket. Cases have been made for both. HFR, for example breaks its HFRX and HFRI indices into strategy types (like fixed-income, equity, macro or event-driven), though institutions most commonly use the full HFRX and HFRI indexes to benchmark their hedge fund portfolios.

The HFRX index is valued daily and is a more concentrated portfolio of 100 funds or so, while the HFRI index, which goes back to 1990, tracks over 2,000 funds and is valued monthly. They both require a minimum asset size of $50 million, with the HFRI index requiring a one-year track record and the HFRX requiring two years, according to HFR's website.

Another problem with hedge fund indices, HFR's or others, is that they are are often plagued by reporting and survivorship bias. Since hedge fund performance information isn't public, the index providers have to rely on the firms to submit their information willingly. Many don't and some tend to stop reporting when their performance gets bad or when they close.

Mark Anson, who oversees investments for Robert Bass's family office, known as Acadia Investment Management, and has held senior investment posts at Oak Hill Investment Management, Nuveen Investments, Hermes and Calpers, told MFWire that he recently surveyed 25 hedge fund managers, asking them if they use a benchmark and whether they submit their performance information to HFRI. Half of these managers said they didn't use a benchmark and only four submitted to HFRI.

Steve Nesbitt, founder and chief executive of Marina-del-Rey, CA-based Cliffwater, a consulting firm that advises institutions on alternative investments, agrees with these assessments. "The HFRI index has significant selection bias," he said.

Two thirds of the managers Cliffwater tracks don't submit their data to HFRI. Though he estimates about 70 percent of institutional hedge fund investors rely on the index. Nesbitt recently helped Virtus Investment Partners build its multi-manager alternative mutual funds and worked with the firm's investment executives on setting benchmarks.

Some managers of new alternative mutual fund products that are hedge-fund-based still advise using the HFR indices to benchmark them, though others argue that this might not make sense, as a '40 Act structure is very different, and much more constrictive, than a hedge fund product.

Morningstar, for its part, already has commodity and managed futures indices and started a hedge fund index in 2003. To be included, the hedge fund has to have a minimum one-year track record and at least $100 million under management. That index tracks about 500 funds. Sanjay Arya, senior vice president at Morningstar Indexes, calls it "the investible hedge fund index," as it only follows strategies that are open to new money.

Meanwhile, it seems the two firms rarely, if ever, cross paths, aside from a distribution partnership they formed in 2012. As with most things when it comes to institutional and retail service providers, they wade in completely different pools, probably hang out on different sides of the river and drink in different bars.

Most institutional investors aren't aware of Morningstar's hedge fund index, while Morningstar believes HFR's indices don't represent an "investible universe" of hedge funds, as many are closed to new investments and/or aren't available to the retail market. The latter may be true, but the former isn't. According to HFR's website, the HFRX index requires funds to be open to new investments. (HFR declined to comment for this story).

Arya added that financial advisors have been looking for a more holistic approach to indexing alternative mutual funds, so Morningstar is working with Ibbotson Associates, which it acquired in 2005, to develop an index that would wrap several types of alternative strategies together.

At least when it comes to alternative mutual funds, the index providers won't have to hunt down managers for performance information, as it will be publicly available, usually via Morningstar. 

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