Replicating hedge fund indices may weaken hedge fund justification

Date: Tuesday, March 27, 2007
Author: Darin Tyson-Chan

The recent practice of replicating hedge fund indices may dispel arguments for having a portfolio allocation to hedge funds, according to a leading executive with Russell Investment Group’s US operations.

“One of the rationales for a hedge fund investment is that they are not correlated with your major market investments. Now, in the US, a couple of the investment banks have started talking about putting out in the marketplace investment products that offer to replicate hedge fund indices,” said Russell US managing director of institutional and research strategy Rob Blackwell.

He believes the method by which these financial institutions are going about imitating the indices is what nullifies the potential portfolio diversification outcome a lot of investors require through hedge funds.

“How do they do that? They go and buy S&P, they buy corporate bonds, they sell treasuries, they’re doing it with public markets. Well, if you can replicate a hedge fund index by investing in public markets, it’s not really telling you that that hedge fund index is uncorrelated with other markets,” Blackwell explained.

Furthermore, he felt that if hedge fund indices can be replicated in this fashion, then perhaps a large amount of the return of hedge fund managers is market driven as opposed to being delivered by strategy and skill, another key reason people find investing in hedge funds attractive.

Blackwell thinks this development may direct investors away from hedge fund managers in preference for more conventional managers.

“My view is that it will encourage investors to look to more traditional managers who are now beginning to offer more hedge fund-like strategies in a more transparent mode,” he said.

“I think there is some really interesting potential there in the development of a different view of what hedge funds are,” Blackwell added.