For years, hedge-fund investors have struggled with inadequate benchmarks – either theoretical indices based on bias-ridden databases or arbitrary cash-plus measures that fail to reflect reality. But things are changing. Investors can now look beyond the inappropriate options of the past and employ fully investable benchmarks instead.

Most investors recognize that the traditional 60/40 equity/bond split is obsolete, because it fails to provide adequate diversification. That’s all too evident today, with equity valuations elevated and bond yields severely compressed.

The need for genuine diversification has prompted many institutional investors to take a multi-asset approach, allocating strategically or tactically to a broad range of assets. This involves using benchmarks to model the performance of various asset classes and help determine the appropriate allocations.

Among those asset classes, hedge funds are of obvious interest. Hedge funds offer the potential for absolute returns in all market conditions with low correlations to the bond and equity markets. That makes a compelling case for alternatives in a multi-asset portfolio.

But there’s a problem. For those interested in allocating to hedge funds, the lack of appropriate benchmarks has been glaring. Until recently, investors have had only two options: theoretical indices from hedge-fund databases or "cash-plus" targets (e.g. cash +3%).

Database drawbacks

Historically, theoretical hedge-fund database indices have suffered from a range of problems stemming from how they are constructed and maintained. Foremost among these is survivorship bias, whereby the exclusion of collapsed hedge funds distorts the performance of the asset class. With only the survivors included, the historical performance data can become highly misleading.

A close cousin of survivorship bias is backfill bias. This arises when successful funds report their past performance to a database, which then includes all of that historical performance. Meanwhile, unsuccessful funds don’t report to the database, so their poor performance continues to be excluded. Most hedge-fund databases are entirely reliant on the willingness of managers to report their performance – and those managers have an incentive to keep quiet when performance has been poor.

Then there is the problem of closed funds reporting to hedge-fund databases. The performance of these funds is real, but it’s entirely inaccessible to new investors. So their inclusion renders those databases less useful to asset allocators, because they reflect performance that investors cannot hope to capture.

There are timing issues too. Managers tend to report their performance with a substantial lag — especially when returns have been lackluster. This is because they hope to mask periods of weakness with subsequent improvements in performance. There’s typically a three-month catch-up period. This is frustrating for asset allocators, as they have to contend with estimated returns rather than real data.

On top of that, databases fail to reflect the time taken to switch between funds when rebalancing, showing it as instantly achievable rather than a process that might take months — and distorting the expected returns along the way.

The cash-plus problem

Because of the inadequacies of hedge-fund databases, institutional investors have tended to use cash plus as a benchmark for hedge-funds at the plan stage. But the pitfalls of this approach are even greater.

Hedge-fund databases may distort reality, but cash plus is simply made up. It’s not an investable asset, so you can’t own it. You can use a cash-plus figure as a target for returns, but it isn’t a true benchmark. If you model an allocation to hedge funds and use cash plus as a proxy, you’ll get a largely linear return stream that would be quite unobtainable in real life.

That return stream doesn’t exhibit the properties of any risk-seeking asset, so it’s useless for modelling purposes. And it will also suggest that your hedge-fund portfolio has zero correlation to equities and almost zero volatility — which is utterly misleading on both counts. So, while investors who allocate to hedge funds might get a return of "cash +3%," they’ll get an entirely different risk profile with it.

Cash plus is also wholly unsatisfactory for assessing the performance of a portfolio beyond its absolute return. It can’t tell you whether you’ve done well in selecting a strategy or in selecting the hedge funds within that strategy. That’s because it’s not comparing the performance of your investments to their peers. It is, quite simply, not an adequate benchmark.

Enter the SAMURAI

Here we should remember the CFA Institute’s criteria for good benchmarking, embodied in the acronym SAMURAI. This stands for specified in advance, appropriate, measurable, unambiguous, reflective of current investment opinions, accountable and investable.

Of these, appropriate is particularly relevant. Hedge-fund databases are often been quite unrepresentative of the opportunities in alternatives, because they contained a disparate mix of strategies, many of which would never be considered by most institutional investors.

But it’s the last of the seven criteria — investable — that is the most important. Investors have to be able to replicate the return that a benchmark shows. And that’s why cash plus is next to useless. If your hedge-fund allocation underperforms your cash-plus target, you can’t just invest in ‘cash plus’ instead – because it doesn’t actually exist.

Nor can you allocate to cash plus while you go through the painstaking process of fund selection. If you have decided to allocate strategically to alternatives, you will probably be parking those assets in cash while you undertake your due diligence – thus missing out on the expected returns from hedge funds. You certainly won’t be parking them in ‘cash plus’.

Meanwhile, investing directly in all of the components of a typical hedge-fund database is an unworkable solution, given the complexity, cost and time required. So large-scale underfunding — amounting to hundreds of billions in U.S. pension assets – is a further unwelcome consequence of uninvestable benchmarks.

A game-changer: the investable benchmark

For all of those reasons, the development of investable hedge-fund indices is a game-changer for institutional investors. This work has been pioneered by HFR, which aims to do for hedge funds what MSCI has done for equities. The company has created a full suite of hedge-fund benchmarks, all of which invest in the underlying funds – and all of which can be tracked by passive investors.

Investable peer-group benchmarks are far more appropriate than either cash-plus approaches or traditional hedge-fund databases. And because they’re both appropriate and investable, they can be used by pension funds at the plan level as a replacement for cash plus."

Investors who use an investable benchmark as a proxy know that they could own it through a tracker fund. This symbiosis between benchmarks and passive funds is crucial. Without passive funds to track it, the S&P 500 Index would be of little use to equity investors. So, with the emergence of investable benchmarks such as the HFR 500 Index, investors can now apply the same scrutiny to their alternatives allocations as they can to their equity portfolios.

Above all, the emergence of genuine, investable hedge-fund benchmarks gives institutional investors a real choice when they make allocations to alternatives. They can measure active strategies against their passive equivalents, with the option of switching to a passive approach at any time. And when undertaking due diligence on active strategies, they can obtain full exposure to the asset class rather than remaining underfunded.

As HFR offers sub-indices organised by strategy, liquidity profile and geography, investors can benchmark specialist active strategies or capture passive returns from specialist areas of the alternatives market that provide even greater levels of diversification than the hedge-fund mainstream.

Above all, the emergence of genuine, investable hedge-fund benchmarks gives institutional investors a real choice when they make allocations to alternatives.

In creating these investable benchmarks, HFR has also addressed investors’ concerns about the quality of hedge-fund indices. The company has a team dedicated to ensuring the quality and timeliness of its data. HFR is subject to third-party audits and is compliant with both the International Organization of Securities Commissions and the European Securities and Markets Authority — something that hasn’t been seen in the hedge-fund world before.

The HFR 500 Index offers an accurate picture of what the hedge-fund universe looks like without the distortions of survivorship and backfill bias. And it looks highly attractive — offering average annual returns of around 5% with volatility of 5.5% over the past 15 years. It has some correlation to equities but offers genuine alpha.

Those characteristics make a compelling case for investing in alternatives. And with the emergence of these investable indices, institutional investors can allocate to alternatives in the knowledge that they can now model returns appropriately and keep their hedge-fund allocations on track.