By Susan Barreto
Most institutional investors have been shoe-horning hedge funds into their portfolios with long-only tools and a few have started to wise up to the fact that benchmarks at best are like having speed bumps on the hedge fund superhighway, but at worst an accident waiting to happen.
It’s all about expectation management when it comes to trustees. And dangling a goal of 5%, 10% or even 12% for hedge fund returns net of fees spells trouble when others are being sold Libor plus 4% or Treasury bills plus 3%. Especially at a time when the value of Libor or T-bills can only rise after hitting all-time lows.
Benchmarking is clearly all over the place, as Richard Harper, a consultant at NEPC, wrote in a recent paper: “By most metrics, absolute return benchmarks behave quite differently from actual hedge fund performance and their usage obscures the distinction between manager skill and market exposure.”
Harper concludes that indices can be helpful as an indicator of hedge fund averages – albeit with their own imperfections such as survivorship bias, selection bias, investment limitations, limited information and reporting issues. Also let’s remember that with the growing trend for customisation such portfolios are not accounted for within indices, which is a problem for users of funds of hedge funds.
Although in the end it all comes back to what are investors buying hedge funds for – alpha or protection. Institutional investors that are relying on hedge funds as a high-performing engine powering their portfolio are now mulling once again whether a risk-free rate or an absolute return index really is valuable when it comes to measuring the success of a portfolio of hedge funds.
Many pension funds currently rely on a commercially offered hedge fund index. But some hedge fund indices in 2008 vastly underperformed the Libor plus 4%. And as the number of hedge fund closures, winddowns and new launches rising from the ashes accelerated over the last two years or so, many indices have been playing catch-up to ensure they are still relevant as benchmarks.
So is benchmarking a speed bump on the investment path or is it a real tool for analysis and comparison? As interest rates rise, investors and managers will know the answer for their portfolio and whether or not they have made it to the right place, even if the destination is a moving target.
One innovative university endowment has been looking at building its own index of indices to match its hedge fund exposure that is spread across its overall investment portfolio. The problem has been that they are unable to find a single hedge fund index provider that offers strategy indices in each area the endowment is allocated in. Let’s face it, special-situation portfolios are special for a reason.
In the long term, trustees – such as those at the Colorado Fire & Police pension fund – are focused on benchmarking returns to T-bills plus 4% which, according to endowment investment officers, makes the most sense as shorter-term yard-sticks represented by indices are elusive. But just in case, Colorado staffers keep an eye on hedge fund averages via indices.
According to Scott Simon, Colorado’s chief investment officer, even as interest rates rise and the benchmark hurdle increases for managers it shouldn’t be a problem as the underlying value of the hedge fund portfolio should also grow. That said, Colorado will reserve the right to review and retain a benchmark on an annual basis.
In a rising interest rate environment, investors are likely to keep an eye on both indices and customised benchmarks, and the option open to change direction if their underlying managers look like they are going to reach their alpha destination late.