What’s In your Index? Part 3 of a 4-Part Series

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How is the information presented?

 In part three of our ongoing series, we look at how and when information is presented when evaluating hedge fund indices.

 As mentioned in our earlier articles on this subject, a quality index can serve as a meaningful benchmark to evaluate manager performance. The index you choose may help determine your overall asset allocation or be the difference between investing in or redeeming from a manager. But when it comes to hedge funds, quality indices have historically been few and far between, leaving allocators with a very limited and often misleading visibility into manager performance.

 This is a problem that, frankly, hasn’t seen the amount of attention it deserves. For example, earlier this year, a working paper by a team of respected academics and government economists at the Federal Reserve found that due to incomplete data, the actual size of the hedge fund industry is as much as 40% larger than most common estimates of $3.5-$4.2tn and performance metrics are grossly understated. Complete peer group data is even more important for strategies that deviate from long only equity or fixed income approaches, which is often the case with hedge funds, where an index of peers may be the most meaningful way to evaluate manager performance.

 We’ve broken down our analysis into four parts, each of which deserves its own level of attention. How can an investor determine whether an index is high quality and serves as a meaningful benchmark?

PivotalPath has developed hedge fund indices that address each of these issues, among many others.  Today, we are covering the third part of our analysis and we will be dedicating a specific article to the fourth part in the near future. At a high level, however, questions that every allocator should be asking include:

  • What are the constituents, or data, that goes into the index?

  • What is the methodology used to construct it?

  • How is the information presented and is speed valued over accuracy?

  • Is there more to the index than the average?

We will address the remaining question in our fourth and final article and provide some additional thoughts to help you determine whether an index should be your benchmark.

With regards to how and when information is presented, hedge fund performance is most commonly provided monthly. Accordingly, hedge fund indices usually follow the same monthly cadence. Based on the liquidity of the strategy, it is reasonable that hedge funds provide their previous month’s returns to index providers throughout the following month. The less liquid the strategy, the longer the returns usually take to report. However, index providers often race against each other to be the first to publish each month, regardless of whether their numbers are stable. 

Most hedge fund indices are sent out without any context as to the number of funds, percentage of those likely to report, how much it has already changed, and how much it is likely to change going forward. Consequently, investors are often frustrated by constant index fluctuations, at times material, from day to day, throughout the month or even months later. Wouldn’t you want to know if the data you were basing your decisions on was likely to change at some point in the near future?

Without some level of transparency into the stability of the number reported, it is just that: a number. And one that is hard to provide confidence in for investors who are trying to benchmark their managers and communicate performance to their clients or board/investment committee members.

What should allocators do? Ask how the stability of monthly performance is measured – i.e., can the allocator distinguish between a number that will hold up over time from one that is likely to change materially?

Contact us to learn how PivotalPath presents its index information and read the entire 4-part series at www.pivotalpath.com.


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