Hedge fund indices: how representative are they?

Hedge fund indices: how representative are they? Pictet Alternative Advisors SA Hedge fund indices aim to quantify the returns of the hedge fund universe. In doing so, they offer a relative basis for comparing absolute hedge fund performance. However, investors should pay careful attention to index construction, which can easily misrepresent performance and may not fully reflect the complexity of the industry. Hedge fund indices Page 4 What are the origins of hedge fund indices? How is a hedge fund index constructed? How does the concept of an index apply to hedge funds? Hedge fund databases Page 5 Do hedge fund databases reliably represent the hedge fund universe? What other database biases exist? The methodologies of index providers Page 7 How do methodologies differ between providers? What is an investable hedge fund index? Fund of hedge fund indices Page 9 Do FoHF indices provide a better representation of the hedge fund universe? Investing in hedge fund indices Page 10 How can you invest in a hedge fund index? What is a hedge fund index replicator? Why is hedge fund index investing popular?

2 Hedge fund indices: how representative are they?

Summary An investor welcomes the opportunity to compare their investments to a credible benchmark. For instance, a UK large cap equities portfolio would typically use the FTSE100 as a benchmark, since the index represents over 80 per cent of UK market capitalisation. Hedge fund investors also value a trustworthy benchmark. However, the complex nature of hedge fund investments creates difficulties in the construction of a suitable measure. In addition, hedge fund database reporting introduces a number of biases that distort the true picture of hedge fund returns. Nevertheless, this has not inhibited their widespread construction and use throughout the industry. In the absence of a more reliable alternative, it remains vital that investors understand the specific characteristics of these indices. 1 Source: Hedge Fund Research. With hedge fund assets totalling over USD 3.0 trillion across more than 10,200 hedge fund vehicles at June 2015 1, an accurate measure of hedge fund performance is unquestionably justified. What was the performance of Global Macro managers in 2008 and 2009? a) +5.6% and -8.8% or b) -21.3% and +36.2% See page 11 Summary Hedge fund indices Hedge fund databases The methodologies of index providers Fund of hedge fund indices Investing Conclusion 3

Hedge fund indices What are the origins of hedge fund indices? Hedge fund indices have tracked the exponential growth of hedge fund assets, first appearing in the 1990s. Their use has grown in line with investor demand. Typically, hedge fund indices are employed in asset allocation studies, proving vital in assessing the impact of hedge fund investments on a broader asset mix. Hedge fund indices also offered the first opportunity to benchmark a manager s performance in an otherwise highly secretive industry. This was further extended to monitor a manager s style drift and investment discipline. How is a hedge fund index constructed? The construction flow of a hedge fund index begins with the hedge fund manager reporting the funds description and performance to a hedge fund database. As hedge funds are private placements, the choice of database and which fund to report is completely voluntary and self-selected. A manager can therefore choose to report its best performing fund to only one index provider or not to report a poorly performing fund. The hedge fund database provider aggregates the various funds that have reported and either gives hedge fund index providers access to its database or constructs indices itself. Typically, the database requires the hedge fund to describe its investments universe, terms and conditions and strategy/style. The index provider then assimilates the hedge fund database universe according to selection criteria which vary across index providers. At this stage, the index provider constructs an index with a new, condensed hedge fund universe that can be further broken down into sub-indices covering the variety of hedge fund strategies and styles. HOW A HEDGE FUND INDEX IS CONSTRUCTED Hedge fund manager Hedge fund manager opts not to report hedge fund to database Hedge fund manager voluntarily reports hedge fund to database Hedge fund database Hedge fund index provider Hedge fund index Hedge fund database filters funds according to selection criteria Hedge fund index provider filters its universe of open and closed hedge funds and categorizes into sub indicies Source: Pictet Alternative Advisors SA How does the concept of an index apply to hedge funds? By definition, hedge funds are absolute return investment vehicles. Therefore, the term hedge fund index, which introduces the concept of relative performance, is immediately counter-intuitive. Although a hedge fund manager operates within a definite strategy, each manager executes the strategy in his own manner. This is the source of any alpha, or skill of a manager, which varies across hedge funds and is a source of hedge fund performance. The existing universe of hedge fund indices offers the investment community several options. Hedge fund indices can be strategy specific, equally weighted, asset weighted, investable, or non-investable. 4 Hedge fund indices: how representative are they?

Hedge fund databases 2 Source: Performance Benchmarks and Survivorship Bias for Hedge Funds and Commodity Trading Advisors. Park, J., S. Brown and W. Goetzmann, 1999. Reported in Hedge Fund News. Do hedge fund databases reliably represent the hedge fund universe? An index should represent a general proxy for an industry. Because of the characteristics associated with the hedge fund industry (i.e., private, unregulated offshore structures), hedge fund databases are subject to several biases that militate against an accurate representation of hedge fund strategies and consequently distort performance. Some biases inflate performance while others may skew index performance downwards. Hence they may only be able to provide a biased estimation of the true hedge fund universe. Cumulative studies have estimated the impact of biases on performances to range between 0.7 per cent to 10.7 per cent per annum. 2 What is self-selection bias? As the hedge fund universe consists mainly of private structures, there is no legal requirement to report performance to the general public. Consequently, reporting to a hedge fund database becomes completely voluntary. This leads to what is known as self-selection bias. Further, there is no obligation to report to all databases and the manager can therefore report to only two or three databases if they so desire. Voluntary reporting is driven by incentives. A manager may opt not to report its performances due to either a bad track record creating an upward bias or because a fund with good performance is closed and wishes to retain its secrecy leading to a downward bias. Managers understandably prefer to report good track records. A 1999 study suggested that self-selection bias causes a performance deviation of 1.9 per cent annually. 2 INDUSTRY COVERAGE BY HEDGE FUND DATABASES CISDM 25.8% TASS 16.7% 2.2% 1.9% 1% 3.2% 1.7% 2.4% <1% 1% 1.8% 12.2% EUREKA 1% 1.5% <1% <1% <1% <1% <1% 1.1% <1% <1% <1% <1% 1% 2.3% 10.2% HFR 5.8% MSCI Source: Inferring Reporting Biases in Hedge Fund Databases from Hedge Fund Equity Holdings, February 2010 http://ssrn.com/abstract=1536886, V. Agarwal, et. al. Figures indicate percentage of funds covered The diagram above shows that less than 1 per cent of the hedge fund industry reports to all databases, highlighting the unrepresentative nature of hedge fund databases. Summary Hedge fund indices Hedge fund databases The methodologies of index providers Fund of hedge fund indices Investing Conclusion 5

A study by Fung and Hsieh in 2000 estimates a performance deviation of 3.0 per cent annually as a result of instant history bias. A study by Barry in 2003 estimates a performance deviation of 3.7 per cent annually as a result of survivorship bias. Side-pockets: hedge funds with a proportion of potentially or actually illiquid assets may separate those assets into side-pockets (subject to restrictive redemption conditions), which allows investors to raise cash by redemptions against the liquid portion of the fund s portfolio. What is instant history bias? Also known as backfill or retroactivity bias, instant history bias is defined as the historical restatement of the index following the addition of a fund. Depending on the provider, there are two instances where instant history bias occurs. First, a database that rebalances the historical returns of an index every time a new fund is added suffers from instant history bias. Second, and more commonly, instant history bias occurs at a launch of an index. For instance, if a new index launches in 2010, it can decide to backfill returns since 2000, therefore only selecting funds that have a suitable track record, instantly disregarding a segment of the universe that has a shorter track record. In both cases, inclusion of funds with good track records leads to overestimating the industry s performance, while those with a bad track record or dead funds are not reported. What other database biases exist? Survivorship bias or liquidation bias occurs when constituents are removed from an index. In the case of hedge funds, survivorship bias commonly occurs when obsolete funds or blow-ups cease to report to a database, which creates an upward bias for a given index. In addition, as private placements, hedge funds may also choose to stop reporting funds which have recently closed to new investors. This would result in a downward bias. Database biases may also be aggravated by a manager s selective choice of the share class to report. For example, the share class reported may not be open to all qualified investors, or the performance reported may not include side-pockets. 6 Hedge fund indices: how representative are they?

The methodologies of index providers HEDGE FUND INDEX PROVIDERS AND THEIR CHARACTERISTICS Start Number of Equal or Investable or date sub-indices asset weighted non-investable Barclay Hedge Fund Indices 1980 27 equal both Dow Jones Credit Suisse Indices 1994 10 asset both EDHEC Alternative Indices 1997 13 equal non-investable Eurekahedge 2000 10 equal non-investable Hedge Fund Intelligence Indices - HFI 1998 61 equal non-investable HFR Hedge Fund Indices 1990 28 equal both Source: Pictet Alternative Advisors SA; An introduction to Core Topic in Alternative Investments, Mark J. Anson How do methodologies differ between providers? Typically, the first area of difference is the decision on selection criteria for fund inclusion. For instance, a provider may exclude any hedge fund with less than a 12-month track record, or only include hedge funds which have assets under management greater than USD200 million. Other criteria that vary between providers can include constraints on operations, underlying financial instruments or liquidity schedules. In some cases, index providers will even go as far as to perform a full due diligence of the reporting hedge funds. Finally, with the creation of subsequent sub-indices, some providers segment their universe into investable and non-investable hedge fund indices. What is an investable hedge fund index? An investable hedge fund index is an index constructed only of hedge funds that are open to investment. Construction of investable indices is usually concentrated so that an index provider can easily replicate the index to meet client needs. Both characteristics contribute to an even smaller hedge fund universe, resulting in significant heterogeneity across providers. Investable hedge fund indices respond to increased demand from those whose resources limit their ability to run an end-to-end hedge fund investment program. Note, however, that contrary to its ostensible meaning, investable does not define an index in which investments can be made. Investments into hedge fund indices are achieved via hedge fund index products and not directly into the indices themselves. Hedge Fund Research (HFR) currently publishes over 70 investable hedge fund indices, under the acronym HFRX. What is a non-investable hedge fund index? A non-investable hedge fund index is an index constructed using both open and closed hedge funds. Non-investable indices, while still representing a subset of the industry, are intended to give a fairer representation of the wider performance of hedge funds generally, by including hedge funds which both can and cannot be invested in. The indices can also be broken down into strategies and styles. For instance, the HFRI indices, published by Hedge Fund Research, include over 25 non-investable indices. Note that not all index providers construct non-investable indices. Summary Hedge fund indices Hedge fund databases The methodologies of index providers Fund of hedge fund indices Investing Conclusion 7

INVESTABLE AND NON-INVESTABLE HEDGE FUND INDEX CHARACTERISTICS Investable Constituents must be open to new investments Suffer from database biases Must be easily replicable Increased biases due to tougher selection criteria (some undergo a full due diligence) Non-investable Constituents can include open or closed hedge funds Suffer less from database biases than investable indices Larger universe to select from Better estimators of the hedge fund universe Construction more concentrated therefore have higher degree of heterogeneity Poor estimators of the hedge fund universe How do selection criteria affect hedge fund index performance across strategies and providers? Returns of hedge fund indices can be highly dispersed because of the varying selection criteria used by different index providers. Moreover, the cumulative performances of an investable and a non-investable index, for the same strategy and from the same provider, are likely to differ significantly. The performance chart below shows that, since April 2005, the Credit Suisse All Hedge L/S Equity (investable) and the Credit Suisse Benchmark Index L/S Equity (non-investable) have a cumulative return of +95.7 per cent and +40.8 per cent respectively: a dispersion of over 54 per cent! The performance between two providers publishing indices on the same strategy also shows considerable dispersion. Over the same period, the HFRI Equity Hedge index (non-investable) and Credit Suisse Benchmark index L/S Equity (non-investable) show a difference of over 29 per cent. HEDGE FUND INDEX DISPERSION Apr 2005 = USD100 200 180 160 140 120 100 80 HFRI Equity Hedge Index HFRX Equity Hedge Index CS Long/Short Equity Index CS All Hedge Long/Short Equity Index non-investable non-investable investable investable +95.7% +66.7% +40.8% +9.6% 60 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Pictet Alternative Advisors SA, data as at 30.06.2015 8 Hedge fund indices: how representative are they?

Fund of hedge fund indices A study by Fung and Hseih in 2000 also estimated that instant history bias for a FoHF is approximately 50 per cent less than for hedge fund indices. Do fund of hedge fund indices provide a better representation of the hedge fund universe? Fund of hedge fund (FoHF) indices are constructed using FoHFs which have decided to report to databases. In comparison to hedge fund indices, FoHF indices include direct representation of hedge fund share classes that may not otherwise be reported. This reduces a database s self-selection bias. Further, when an underlying hedge fund liquidates, blows up or sets up side-pockets, the investing FoHF does not restate historical performance. All these factors contribute to a better representation of the hedge fund industry, while also limiting the database biases described above. What are the limitations of fund of hedge fund indices? While a better reflection of the hedge fund universe, FoHF indices still contain biases of their own. A FoHF typically undertakes thorough due diligence and would therefore invest in top performing hedge funds, avoid strategies that demonstrate high liquidity risks and exclude funds exposed to pitfalls. Furthermore, the hedge funds in which FoHFs invest in include tactical cash allocations, whereas hedge fund indices are typically 100 per cent fully invested. Unlike a direct hedge fund investment, investments in FoHFs incur a double layer of fees which dilutes performance. FoHF indices also suffer from self-selection bias. How does fund of hedge fund index performance compare across providers? FoHF indices also exhibit a wide dispersion between providers. The chart below compares four FoHF indices, each with a common track record since December 1999. Over the fifteen year period, there is a cumulative difference of 22 per cent between the highest and the lowest performance. Whether the performance of the pure hedge fund index the InvestHedge Composite index is any more reliable is difficult to assess, since it sits mid-way between the two extremes. DISPERSION ACROSS FOHF INDEX PROVIDERS Dec 1999 = USD100 220 200 HFRI Fund of Funds Composite Index Eurekahedge Fund of Funds Index InvestHedge Composite Index EDHEC Funds of Funds 180 160 140 120 100 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: Pictet Alternative Advisors SA, data as at 30.06.2015 Summary Hedge fund indices Hedge fund databases The methodologies of index providers Fund of hedge fund indices Investing Conclusion 9

Investing in hedge fund indices How can you invest in a hedge fund index? Investors assume that investments into a hedge fund index can be made via investable hedge fund indices. However the term investable indicates merely that its constituents are open to investment, rather than an index in which investments can be made. Hedge fund index investing is achieved via products known as trackers. What is a hedge fund index tracker? A hedge fund index tracker is a collective investment vehicle designed to replicate the performance of a hedge fund index by investing in the underlying hedge funds. What is a hedge fund index replicator? Replicators offer a synthetic hedge fund exposure by investing in market factors. They mainly seek to replicate non-investable indices and are constructed using three approaches: factor analysis; dynamic trading or payoff/distribution replication,or reverse engineering/bottom-up approach. Why is hedge fund index investing popular? Trackers and replicators create a source of hedge fund beta in a single product. Access to the hedge fund universe via index products offers a cost efficient alternative to FoHF investments because there is no double layer of fees. Furthermore, they are considered resource efficient, as they eliminate the need for a dedicated hedge fund selection team. Index products also usually offer daily liquidity with no lock-ups and typically have lower fraud risk, as they replicate hedge fund returns via traditional financial instruments such as futures or exchange traded funds (ETFs). However, one of the main drawbacks of hedge fund index products is a drag on performance. What is hedge fund beta ( alternative beta )? While alpha (manager skill) is the element of returns in a portfolio that cannot be explained by risk factors, beta is the portion of returns that can be explained by risk factors. In other words, beta is a measure of the systematic risk of a financial instrument relative to the market. Hedge fund indices may therefore be considered to have introduced a beta for the hedge fund universe, to the extent that managers following the same strategy employ a similar investment process. That part of returns due to investment style or process represent a common risk factor in the strategy, and are known as hedge fund beta or alternative beta explaining an element of strategy returns. How does a FoHF index performance compare with a hedge fund index tracker? The chart below demonstrates the outperformance of a FoHF index versus a hedge fund index tracker. It can be argued that the opportunity cost of investing in a tracker versus a FoHF is a loss of performance, despite the operational efficiencies mentioned above. FOHF INDEX VERSUS HEDGE FUND INDEX TRACKER PERFORMANCE Dec 2003 = USD100 160 150 140 130 120 110 100 90 80 HFRI FoF Diversified Index HFRX Global Tracker Fund 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Pictet Alternative Advisors SA, data as at 30.06.2015 10 Hedge fund indices: how representative are they?

Conclusion Which index should be used? In theory, to monitor the global performance of the hedge fund universe or when undertaking an optimal portfolio allocation study, FoHF indices, either composites or strategy indices, are the most reliable. However, in practice, many investors gravitate towards the Dow Jones Credit Suisse and HFR hedge fund indices. Use of these must come with an understanding of the biases discussed above. To benchmark fund of hedge fund performance, multi-strategy FoHF indices offer the most relevant reference. In terms of benchmarking a thematic FoHF, then single strategy FoHF indices are most suitable. Comparing FoHF indices with a diversified hedge fund portfolio of concentrated investments, managed by Pictet Alternative Advisors SA, dispersion is reduced. Selecting the most appropriate index to compare a FoHF with depends on the profile of the underlying funds. In this case the HFRI FoF Diversified index is most closely aligned with the portfolio. Understanding that major differences exist across hedge fund indices is fundamental to an investor who wishes to be able to benchmark the performance of an individual hedge fund or an FoHF against the industry as a whole. When an investor wishes to estimate the performance of the hedge fund industry, understanding that this differential exists across hedge fund indices and FoHF indices is also fundamental. 3 Track record of PAA concentrated multi-strategy hedge fund portfolio, Mosaic class J, since inception. FUND OF HEDGE FUND INDEX DISPERSION June 1994 = USD 100 450 400 350 HFRI FoF Composite Index HFRI FoF Diversified Index Diversified HF Portfolio³ 300 250 200 150 100 50 0 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Source: Pictet Alternative Advisors SA, data as at 30.06.2015 Answer to the question on page 3: both a) and b) are correct. HFRX Macro index posted +5.6% and -8.8% in 2008 and 2009 respectively. Credit Suisse Blue Chip Global Macro Hedge Fund index posted -21.3% and +36.2% in 2008 and 2009 respectively. This document is not intended for persons who are citizens of, domiciled or resident in, or entities registered in a country or a jurisdiction in which its distribution, publication, provision or use would violate current laws and regulations. In particular, investment funds or any other collective placement instruments which have not been authorised for public offering in the investor s country of domicile may only be offered as private placements to qualified investors. Additional investment restrictions may be provided for in the official offering documentation (available upon request).the information and data furnished in this document are disclosed for information purposes only; the Pictet Group is not liable for them nor do they constitute an offer, an invitation to buy, sell or subscribe to securities or other financial instruments. Furthermore, the information, opinions and estimates in this document reflect an evaluation as of the date of initial publication and may be changed without notice. Information and opinions presented in this document have been obtained from sources believed to be reliable, and, although all reasonable care has been taken, the Pictet Group is not able to make any representation as to its accuracy or completeness. The value and income of the securities or financial instruments mentioned in this document are based on rates from the customary sources of financial information and may fluctuate. The market value may vary on the basis of economic, financial or political changes, the remaining term, market conditions, the volatility and solvency of the issuer or the benchmark issuer. Moreover, exchange rates may have a positive or negative effect on the value, the price or the income of the securities or the related investments mentioned in this document. 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