New Approach To Hedge Fund Indexing

Date: Tuesday, September 18, 2007
Author: Heather Bell, Indexuniverse.com

In the past, hedge fund indexes have followed one of two models. Either they tracked the performance of actual hedge funds, or they tracked the performance of quantitative strategies designed to mimic the returns characteristics of various hedge funds.

But a new index from Bear Stearns takes a third approach to tracking the space, actually replicating the hedge fund strategy using a passive approach. The Bear Stearns Risk Arbitrage Cash Deal Index tracks the largest companies in the U.S. that are the targets of definitive, pending all-cash acquisitions, and aims to capitalize on the difference between the companies' current share prices and the promised deal payouts. Although the company has studiously avoided using the term "hedge fund" in association with the index, merger arbitrage is a strategy typically associated with the hedge fund space.

The market cap-weighted index contains a maximum of 25 companies, with a minimum market capitalization of $300 million. There must be a difference between the current stock price and the deal consideration of at least $0.25/share. The weights of individual components are capped at 7.5% of the index, with any excess weight redistributed among the other components according to market cap. The index is rebalanced weekly. If a deal closes or terminates, the affected component is removed at the next rebalancing. As of August 31, the top companies in the index, all with a 7.5% weighting, were TXU Corp., First Data Corp., Alltel Corp., SLM Corp., Hilton Hotels Corp. and Harrah's Entertainment Corp.

Bear Stearns Trading Stragist Justin Lubell says that the company's equity-linked strategy team has been working on developing passive absolute return strategies since last December. Although risk arbitrage was just one of the strategies the group was working on, Lubell says the time seemed right to launch it.

"Arbitrage spreads became meaningfully wider over the last couple of months, and we got a lot of calls from investors who were interested in participating in risk arbitrage strategies in general but who weren't interested in investing in individual stocks," Lubell says.

During late July and into August, when the S&P 500 was down almost 10%, Lubell says the Bear Stearns index was down roughly 5% and at the same time displayed about half the volatility of the large-cap benchmark. The index was up 2.1% for August versus a 1.3% increase for the S&P 500.

He adds that investors had been asking for investment vehicles that provide access to the strategy and says products based on the index will be available: "All of the standard types of structures that people apply to indices, we intend to use this index for."

But the index is also designed as a benchmark for investors in the category to use for evaluation purposes, and Lubell says that the intent was to design an index that captured the average performance of the strategy.

"I think there's a lot of interest in the fact that this is an index methodology as opposed to just a basket. And there's been a lot of interest in the idea that people can use this as something of a benchmark or proxy to measure the performance of cash deal spreads in general, as opposed to just looking at the performance of asset managers," he adds.

Strategy indexes of this type are a rarity so far, and Bear Stearns is definitely covering new territory. However, it is not clear what other investment strategies could be fit into a similar index format.

The big question, of course, is whether and how soon we will see passive products tied to this strategy ... a move that could be a boon for investors, as the lower costs of passive investing could help boost the total returns from this style of investing.

Still, there are issues. Weekly rebalancing seems extreme, and while it might be fine for an index underlying certain types of products, it may be difficult for an index fund or ETF due to the transaction costs (and potential tax overhang) involved. Perhaps an ETN? Bear Stearns has already launched one of those, and is likely looking to expand in that market.