Hedge Fund Indices: Can They Be Used as Performance Benchmarks?

One of the requirements of institutional investors such as endowments, foundations and pension funds is a performance benchmark for a fund.  For mutual funds, there are a series of well-defined indices that serve in this capacity.  For Large Cap Equity in the US, there is the S&P 500 or Dow Jones Industrial Average.  The Small Cap Equity benchmark in the US is the Russell 2000.  A country may have an index such as Great Britain's FTSE 100 or Japan's Nikkei 225.  Bonds have their own indices based on their type"  US Treasury, High Yield, Mortgages, etc.  This allows the investor to compare a fund's returns relative to their investment universe's benchmark and find their outperforming and underperforming managers.

It is more difficult to find a proper index for hedge fund managers.  The more famous ones are the Dow Jones Credit Suisse, Hennessee Group, Eurekahedge, Barclay and MSCI.  Mutual fund indices are transparent to the public.  On the other hand, the opaqueness of hedge funds creates issues with finding a proper index for a manager.  The following issues are highlighted in Mark Anson's Handbook of Alternative Assets which is one of the source books for the CAIA program.

• Indices do not contain the same hedge funds
• Survivorship bias is a problem for newly created indices.  Since surviving funds are still in business because of superior returns, they cause the index to overestimate the return of all funds by 2.6% to 5% annually.  Most funds that close do not report their returns as they have more important responsibilities such as returning cash to their investors.  Survivorship bias may not affect indices' return history because the failing managers' performance data are retained in the historical data.
• Instant history bias occurs when the manager, after a period of good performance, decides to add his fund to the index.  Unlike mutual funds, reporting is voluntary in the hedge fund industry.  In addition to the current period, the manager will provide his historical performance.  This causes backfilled performance to be overestimated by 1% to 5% per year. This does not affect indices are they do not re-state historical numbers.
• Liquidation bias increases the performance of indices as failing or closing funds will no longer report their returns.
• Each index has its own definition for categorizing hedge fund investment strategies.  Also, managers are able to use a different strategy if the original strategy is not working or does not have enough investing opportunities.
• Access bias happens because many funds are closed to new capital.  A complete index would have open (investable) and closed (non-investable) funds.  This affects indices that report returns on a daily basis as their fund universe is restricted.  They can only include investable managers that do not invest in illiquid assets.  Because of this, investable indices underperform noninvestable indices.  The better managers manage funds that are oversubscribed i.e. there are too many investors with too much capital.
• The 2 and 20 fee structure can distort index returns.  Indices take into account fees when calculating performance.  Incentive fees are paid out annually but indices report on a monthly basis.  The incentive fees have to be estimated each month.  The total of the monthly fees may be different that the actual fee.  Also, the funds in the index may have different fees.  They can range from 1 and 15 to 3 and 50.
• Indices' components and calculations are different
• Turnover due to funds that start reporting and high attrition rate
• Including Managed Futures funds
• Type of index:  asset versus equally weighted 

Anson's summary concludes, "Perhaps the best way to choose a hedge fund index is to first state clearly the risk and return objectives...With this as their guide, investors can then make an informed benchmark selection."