Hedge Fund Index Debacle

Date: Friday, July 20, 2007
Author: Matthew Hougan- Indexuniverse.com

Another day, another hedge fund indexing debacle.

Credit Suisse/Tremont, one of the most popular hedge fund indexers, issued a bit of a revision to one of its indexes yesterday. After reporting on Monday that its fixed-income arbitrage index was up 0.21% in June, CS/Tremont reversed course on Wednesday and said that the index was actually down 6% for the month. Year-to-date returns dropped from positive 3.7% to negative 7.5%

Oops.

The reason? The implosion of the Bear Stearns hedge funds caught in the web of the subprime mortgage meltdown. Those funds did not report returns on time to Credit Suisse, which calculates the CS/Tremont benchmarks. And when they did - poof - the indexes took a tumble.

Every time there's a hedge fund disaster, it seems, another hedge fund index gets dragged into the muck. The S&P Hedge Fund Indexes stopped publication following the Amaranth implosion. And now Bear Stearns difficulties have made a mess of the CS/Tremont benchmarks (and by extension, the composite).

The problem with hedge fund indexes is that they rely on the reporting of individual hedge funds, and a limited number of hedge funds at that. As a result, a single fund implosion can have a major impact on the index, as it did on Wednesday. What's worse, investors in products designed to track these benchmarks are exposed to the same one-off risks. We think of indexes as diversified strategies, but for hedge funds, that's not always the case.

Even when nothing bad happens, however, the actual returns generated by hedge fund indexes often do not reflect the real-time returns of the underlying investments. Nor do the hedge funds themselves.

When hedge funds hold assets that are difficult to price - say, private companies or illiquid securities - managers have to value those assets on a regular basis to produce return numbers. None of these managers value assets in real-time, and many don't even value each asset on a monthly basis. The result is what's known as "serial correlation," when lagging valuation causes there to be undue correlation between this month's return and next month's return ... a "smoothing of monthly returns," to use the phrase of art (http://www.aima.org/uploads/Citigroup.pdf).

This serial correlation is thought to be one of the primary causes of hedge funds' alleged non-correlation to equity markets. In effect, hedge fund valuations (and by extension, hedge fund index valuations) are wrong, with valuations lagging the real-time marketplace. As a result, the return statistics differ from the live equity market returns, because the forces driving the equity market lag in the hedge fund universe.

Wednesday was a special case, when a rare, one-off exogenous event revealed a major flaw in a major hedge fund index. But even when things go smoothly, the numbers churned out by these hedge funds may not be as accurate as they at first appear.