By Susan Barreto
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
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
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