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Hedge Fund Indices from an Academic Perspective: Reconciling Investability and Representativity

Following a growing concern among investors about the quality of hedge fund index return data, and given the lack of capacity and transparency specific to that industry, this paper questions from an academic perspective whether it is feasible or not to design hedge fund benchmarks satisfying all defining properties for a good index. In particular, in an attempt to test whether achieving investability necessarily comes at the cost of representativity, as sometimes claimed by hedge fund index providers, we borrow from the asset pricing literature the concept of factor replicating portfolios and apply it to the benchmarking of hedge fund style returns. Our results suggest that it is actually possible to construct representative indices based on a limited number of funds, except perhaps in the case of Equity Market Neutral strategies, provided that i) these funds are suitably selected and ii) an optimal portfolio is designed with the objective of replicating the common trend in hedge fund returns for a given strategy. A wide range of tests are performed that show that high correlation of the factor replicating portfolios with the common factor of returns for each strategy is remarkably robustness with respect to modifying the number of funds in the replicating portfolio, choosing less correlated funds, changing the frequency of rebalancing, using a static selection of funds or imposing constraints on weights. Edhec is one of the top five business schools in France owing to the high quality of its academic staff (100 permanent lecturers from France and abroad) and its privileged relationship with professionals that the school has been developing since its establishment in 1906. Edhec Business School has decided to draw on its extensive knowledge of the professional environment and has therefore concentrated its research on themes that satisfy the needs of professionals. Edhec pursues an active research policy in the field of finance. Its “Risk and Asset Management Research Centre” carries out numerous research programs in the areas of asset allocation and risk management in both the traditional and alternative investment universes. Copyright © 2004 Edhec