investable hedge fund indices: an assessment and review · investable hedge fund indices – an...

Investable Hedge Fund Indices: An Assessment and Review

ABSTRACT:

Investable Hedge Fund Indices (IHFI’s) have grown in numbers since the first meaningful introduction of these during 2003. While making their presence wide spread through a number of main providers, investors have been left with the task of considering whether or not IHFI’s achieve in practice a better if not outright alternative to established Hedge Funds of Funds (HFOF’s ). What the assessments provided by this report show is that IHFI’s are not very different to HFOF’s and in many ways HFOF’s remain a more viable alternative. Large dispersions are shown to exist for the same types of Hedge Fund Strategies amongst the different IHFI providers. The subscription and redemption costs, notice periods and annual fees make the actual performance which investors can expect to realise from Buy and Hold investing, substantially less than that reported for the underlying indices on which the IHFI’s are based. In summary, many practical challenges remain open with investing in IHFI’s and will require considerable time and resources to shift the vote towards IHFI’s away from HFOF’s if at all.

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Copyright 2004, all rights reserved Jacobson Fund Managers Ltd. 1

Investable Hedge Fund Indices – An Assessment and Review

ABSTRACT: Investable Hedge Fund Indices (IHFI’s) have grown in numbers since the first meaningful introduction of these during 2003. While making their presence wide spread through a number of main providers, investors have been left with the task of considering whether or not IHFI’s achieve in practice a better if not outright alternative to established Hedge Funds of Funds (HFOF’s ). What the assessments provided by this report show is that IHFI’s are not very different to HFOF’s and in many ways HFOF’s remain a more viable alternative. Large dispersions are shown to exist for the same types of Hedge Fund Strategies amongst the different IHFI providers. The subscription and redemption costs, notice periods and annual fees make the actual performance which investors can expect to realise from Buy and Hold investing, substantially less than that reported for the underlying indices on which the IHFI’s are based. In summary, many practical challenges remain open with investing in IHFI’s and will require considerable time and resources to shift the vote towards IHFI’s away from HFOF’s if at all.

1. INTRODUCTION The rise of the hedge fund of funds (HFOF’s) industry, and its additional layer of fees imposed upon investors above that of individual underlying hedge funds begs the question as to whether sufficient value is added in all cases to justify such fees beyond that created by simple scale economies. It would appear that in many, although not all cases, the overlay fee is justified due to provision of tangible investment management services. The introduction of “Investable Hedge Fund Indices” (IHFI’s) during 2003 by various sponsors has created an opportunity at the margin for investors to weigh such HFOF’s fees against a ‘passive’ investment in IHFI’s. This report quantifies the performance net of expenses of holding a portfolio of these instruments, and investigates whether, in full consideration of transaction costs and investment restrictions, a simple trading allocation model might provide superior investment performance. In addition to evaluating the returns to buy and hold strategies, this report tests if either the momentum and mean reversion effects of Debondt & Thaler (1985, 1989) can be found amongst supposedly pure alpha generating investments such as hedge fund strategies. We find in general that some positive serial correlations exist in IHFI returns over short measurement periods such as one month, but that this relationship tends to deteriorate when longer time periods are used, where there is a greater incidence of negative serial correlations. This would suggest that over shorter holding period’s momentum type strategies might be optimal, but mean-reversion type strategies might be more profitable over longer holding periods. We perform an additional series of tests using Rachev Ratios for ranking purposes and portfolio formation, which have the benefit of accounting for non-Gaussian return distributions and adjusting for risk. For our full sample period, before taking account of costs and fees, equally weighted “buy and hold” portfolios yield annualized returns of 8.81%, 8.81%, 10.57%, 9.38% and 9.55% for HFRX Certificates, HFRX Funds, MSCI Lyxor Funds, FTSEhx Funds, and SPhinX Funds respectively, with a combined portfolio based on these index groups earning an average of 9.42% per annum over this period. With costs and fees these returns fall to 6.35%, 7.32%, 9.05%, 8.24%, and 8.16% respectively, for a combined average portfolio return of 7.83%. The average effect of costs is a reduction in annualized return of -16.9%. Despite the effect of costs, in the majority of our tests a simple momentum model yields higher returns then a buy/hold strategy. The presence of some negative serial correlations also creates some situations in which a simple strategy of buying the poorest performers will outperform a buy and hold strategy as well. However, when considering risk adjusted measures, the results of our tests using the Rachev Ratio based momentum model show that after accounting for transaction costs, all scenarios in our test period fail to generate returns greater than a buy and hold strategy. When the Rachev methodology is applied to a Contra/Reversal strategy, there are some situations where profitable strategies may exist. However all of the aforementioned results may be anomalous due to stale pricing or valuation averaging effects with respect to certain strategies. Certainly it is interesting to note the article by De Souza and Gokcan (2004) who have argued that studies showing superior risk/return characteristics of hedge funds are misleading. They attempt to demonstrate that most hedge fund strategy returns display significant amounts of serial correlation due more to NAV valuation than performance effects.


In overall terms as based on the findings of this report, we find investing in Hedge Fund Investable Indices to be less than straightforward with many unresolved issues remaining. Investing on a Buy and Hold basis does not appear in all cases to offer an acceptable risk/reward position when compared to active management of HFOF’s. Investors may not actually be able to realize profitable benefits from Buy and Hold that are risk/reward beneficial in practice, and strategies such as Contra/Reversal may pose significant operational and market risk issues. Funds of Funds may, for many of their own shortcomings, generally remain a more beneficial option for the time being until a more mature and commoditised investable index market develops. The reminder of this report is provided on four further sections. In the next section we review the data sets available for IHFI’s. In section 3 we consider a number of alternative investing strategies in IHFI’s ranging from Buy and Hold to contra and mean reversion approaches. Section 4 provides a discussion of the results and the final section provides the main conclusions. 2. DATA Our dataset consists of monthly returns of the available set of Investable Indices from Jan 1998 – Sept 2004. This consists of investment instruments designed to track the indices of four calculation groups: FTSE Hedge Indices, HFRI Indices, MSCI Hedge Invest Indices, and Standard & Poor’s Hedge Fund Indices. The FTSEhx Funds are investments emulating the FTSE Hedge Indices and are available through MSS Capital. FTSEhx returns have been derived from pro forma NAV's supplied by MSS capital and are net of approximately 1.06% per annum expenses (See Appendix A). As returns are NAV-NAV, no adjustment for fees has been performed. HFR Asset Management is both the calculation agent and investment provider for certain instruments which track the HFRX Indices. These investments take the form of either direct investment in funds managed by HFR asset management, and investment in “Index-Linked Certificates,” which are technically debt instruments of major investment banks and whose return is tied to the performance of specified indices. The difference between these two types of instruments are that direct investment funds levy no transaction costs in terms of purchases and sales of shares, and offer trading only infrequently, at month-end, subject to a 15 business day notice. Index certificates on the other hand offer continuous trading both Over-the-Counter (OTC) and on the Swiss Exchange, subject to a bid-ask spread, and generally have higher ongoing expenses related to fees charged by the Investment Bank. The designated primary market maker for HFRX Index Certificates on the Swiss Exchange is currently Dresdner Bank, which currently quotes a spread of 1.4 % versus the bid side of the market bid-offer differential. As such securities are thus relatively illiquid; an accounting convention would properly apply to investors in index certificates where such securities are valued on the basis of closing or most recent bid price in the case of long position. On this basis, therefore an investor in the HFRX certificates can be assumed to incur an instantaneous unrealized loss equal to the amount of the bid offer spread. As only limited history is available for the HFRX indices, HFRI returns have been substituted after appropriate adjustments have been made. HFRX Returns prior to April 2003 are pro forma reconstructed on the basis of historical returns of the relevant HFRI indices. Correlations, slope estimates, and y intercepts have been estimated using data for the HFRX indices from 1st April 2003 through 1st October 2004. HFRI data were then adjusted by relevant slope and intercept factors. Returns are adjusted further downward by 1/12 of relevant fees listed in Appendix A. In the case of index certificates, returns have been further reduced by the amount of transaction cost denoted where applicable. MSCI Lyxor Funds are offered through Societe Generale, parent of Lyxor Asset Management, MSCI Lyxor returns are shown net of 1/12 annual expenses as per Appendix A. SPhinX Funds data were provided by fund manager PlusFunds group. The SPhinX funds are designed to track the performance of Standard & Poor’s Hedge Fund Investable Indices. Pro Forma monthly returns are used from January 1998 to September 2002. Actual figures are used from October 2002 to present and 1/12 of PlusFunds' investment management fee represented in Appendix A has been deducted from monthly returns.



2.1 Descriptive Statistics Monthly descriptive statistics for 76 monthly returns for each index are set forth in Table 1. In all cases, our sample means are positive. However, due partially to the relatively small sample size in consideration, none of the indices are significantly different from zero at the 95% confidence level. Additionally, monthly sample standard deviations in most cases are greater in magnitude than mean returns. Of further note is evidence of non-Gaussian distributions in the sample data. Evidence is present in numerous indices of negative skew and substantial excess kurtosis (or ‘fat tails’). Cumulative returns for each index are set forth by provider and by style in Figures 1- 13. The most pronounced result observed based on both the summary statistics of Table 1 and the cumulative performance graphs shown in Figures 5-13 is the dispersion amongst the same strategy (or strategy types) relative to the different providers. This dispersion cannot be attributed simply to statistical uncertainty. It is to do with the realization that the underlying managers selected in each of the individual strategies, even for the same strategy type, are providing unequal although highly correlated returns. In addition, part of the differences can be attributed to the different costs and fees as summarized in Appendix A. There is ample evidence provided by these results that equal risks are not being rewarded by equal returns and more particularly, risk adjusted returns. In general, the same style returns are not equal or homogenous across the individual investable index providers. If shorting positions were to become available for these investable indices, arbitrageurs would have a field day at the expense of the underlying investors attempting to achieve a specific exposure and stable returns profile. Of further importance is the observation that the timing and notice periods required across the different investable indices means that a key virtue of being able to move quickly in and out of a specific style is not a uniformly available feature. The so called lock-up feature already familiar to HFOF’s investors is also present with investable indices for the time being. Table 1: Descriptive Statistics, Investable Hedge Fund Indices Including Pro Forma results for defined periods

FTSE Hedge FTSE Hedge Index Directional Event

Driven Non- Directional Convertible

Arbitrage

CTA Managed Futures

Distressed Opportunities

Equity Arbitrage

Equity Hedge

Fixed Income Relative Value

Global Macro Merger

Arbitrage Mean 0.78%

1.13%1.18% 1.87%

0.46% 1.47%

0.39% 1.01%

0.80% 1.04% 0.50% 0.44% 1.25% 0.15% 0.94% 2.06%

0.41% 1.01%Standard Deviatio n

Sample V iance 0.01%

0.04%

0.02%

0.01%

1.67% 4.59% 2.23% 1.18% 2.38% 1.49% 0.04%

0.01%ar

Kurtosis 2 7

1 6

7 7

.41

0.03% 0.21% 0.05% 0.01% 0.06% 0.02% 1 36

5 2.0

0 2 .3

.9 0 0 .9

.7 1 8 - .9

18

86 -

1.21 -

0.71-

4.89 -

0.92 0.56

3.77

44.60 -

. 0 24 - .

.0 1 0 - .4 Skewness

2. 0.25

0.14

1.57

0.99

5.89

HFR Indices Macro Index

Relativ e Value

Arbitrag e Index

Convertible Arbitrag e

Index Merger

Arbitrage Index

Distressed Securities

Index

Event-Driven Index

Equity Hedge Index

Equity Market Neutral Index

Mean 0.63% 1.72%

0.39% 0.64%

1.20% 1.48%

0.56% 1.18%

0.70% 0.68% 0.71% 0.46%Standard Deviatio nSample V iance

0.03%

0.00%

0.02%

0.01%1.71% 1.84% 2.19% 0.98%

arKurtosis

0 4

2 .58

3 6

.040.03% 0.03% 0.05% 0.01%

.7

0 1 .3

2

3 6 - .0

0 9 - .9

11

47 - 8.00

- 5.80

- 1.50

0.63

0.47Skewness

.4 2.

1.71

1.58

0.28

MSCI Hedge CB

Arbitrage CTA

Managed Futures

Event Driven Forex

Trading Global Macro

LS Equity Long Bias

LS Equity No Bias

LS Equity Variable

Bias Mean 1.13%

1.28%1.04% 3.34%

0.75% 1.75%

0.62% 3.76%

0.78% 0.95% 0.85% 1.47%Standard Deviatio nSample V iance

0.02%

0.11%

0.03%

0.14%2.09% 2.56% 2.91% 2.77%

arKurtosis

9 2

0 1

4 9

060.04% 0.07% 0.08% 0.08%

.5

2 6 .3

.0 0 4 - .1

.5 1 4 - .3

0. 46 0.

0.20

6.47 -

9.74

3.12 1.30Skewness

0.44

1.28

1.74

S&P Hedge Fund Indices S&P Hedge Fund Index

S&P Arbitrag e

Index S&P

Directional/ Tactica l

Index S&P Event- Driven Index

S&P Managed Futures Index

Special Situations

Merger Arbitrage Distressed Macro

Managed Futures

Long/Sh ortEquity

Fixed Income

Arbitrage Convertible Arbitrage

Market Neutral

Mean 0.60% 0.89%

0.49% 1.21%

0.71% 1.66%

0.56% 1.41%

0.78% 0.61% 0.35% 0.68% 0.57% 0.72% 0.76% 3.07%

0.23% 3.00%

0.82% 0.42%Standard Deviatio nSample V iance

0.01%

0.01%

0.03%

0.02%4.79% 1.83% 1.38% 1.75% 1.95% 3.64%

0.09%

0.09%1.21% 1.52%

arKurtosis

0 1

2 .01

0 8

370.23% 0.03% 0.02% 0.03% 0.04% 0.13%

6 42

.230.01% 0.02%

.6

0 3 - .4

2

3 5 -

.2 0 8 - .0

9. 38 - 2.

0.12-

13.82 -

4.39 -

2.43 - 1.22

0.75

0.07 - 0.07

. 1 56 - .

60

7 7 -

1.11 -

0.36 0.33Skewness .2 0.05

2.63

1.54

0.36

.3 0.47

Figure(s) 1-4 Investable Hedge Fund Indices by Provider Based on Pro Forma Data Figure 1: FTSEhx Funds- Cumulative P/L, Jan 1998 Through May 2004

Pro Forma Returns Jan 1998-Mar 2004, Actual Apr 2004-May 2004

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FTSE Hedge Index FTSEhx- Directional FTSEhx- Event DrivenFTSEhx- Non-Directional FTSEhx- Convertible Arbitrage FTSEhx- CTA Managed FuturesFTSEhx- Distressed Opportunities FTSEhx- Equity Arbitrage FTSEhx- Equity HedgeFTSEhx- Fixed Income Relative Value FTSEhx- Global Macro FTSEhx- Merger Arbitrage

Figure 2: HFRX Indices, Cumulative P/L With Costs Jan 1998 Through Sept 2004

Pro Forma Returns Jan 1998- Mar 2003, Actual Returns Apr 2003-Sept 2004

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HFRX Macro Index HFRX Relative Value Arbitrage Index

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HFRX Convertible Arbitrage Index HFRX Merger Arbitrage Index HFRX Distressed Securities Index HFRX Event-Driven Index HFRX Equity Hedge Index HFRX Equity Market Neutral Index


Figure 3: MSCI Lyxor Funds, Cumulative P/L With Costs Jan 1998 Through Aug 2004 Pro Forma Returns Jan 2000-Jul 2003, Actual Returns Aug 2003 to Aug 2004

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MSCI Lyxor CB Arbitrage MSCI Lyxor CTA Managed Futures MSCI Lyxor Event Driven MSCI Lyxor Forex Trading MSCI Lyxor Global Macro MSCI Lyxor LS Equity Long Bias MSCI Lyxor LS Equity No Bias MSCI Lyxor LS Equity Variable Bias

Figure 4: SPhinX Funds, Cumulative P/L With Costs Jan 1998 Through Sept 2004

Pro Forma Returns Jan 2000- Sept 2002, Actual Returns October 2002-Present

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SPhinX Hedge Fund Index SPhinX Arbitrage Index SPhinX Directional/Tactical Index SPhinX Event-Driven IndexSPhinX Managed Futures Index SPhinX Special Situations SPhinX Merger Arbitrage SPhinX DistressedSPhinX Macro SPhinX Managed Futures SPhinX Long/Short Equity SPhinX Fixed Income ArbitrageSPhinX Convertible Arbitrage SPhinX Market Neutral


Figures (5-13) Investable Hedge Fund Indices by Style Based on Pro Forma Data. Figure 5: Distressed Strategies, Cumulative P/L, Actual and Pro Forma Data, Feb 1998-May 2004

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FTSE Distressed Opportunities HFRX Distressed Securities Index SPhinX Distressed

Figure 6: Equity Arbitrage Strategies, Cumulative P/L, Pro Forma and Actual Data, Feb 1998 through May 2004

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HFRX Merger Arbitrage Index FTSE Merger Arbitrage FTSE Equity Arbitrage SPhinX Merger Arbitrage


Figure 7: Equity Hedge Strategies, Cumulative P/L, Pro Forma and Actual Data, Feb 1998 through May 2004

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FTSE Equity Hedge HFRX Equity Hedge Index HFRX Equity Market Ne

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04

utral Index SPhinX Long/Short Equity MSCI Lyxor LS Equity Long Bias MSCI Lyxor LS Equity No Bias MSCI Lyxor LS Equity Variable Bias SPhinX Market Neutral

Figure 8: Event Driven Strategies, Cumulative P/L, Actual and Pro Forma Data, Feb 1998-May 2004

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FTSE Event Driven HFRX Event-Driven Index MSCI Lyxor Event Driven SPhinXS&P Event-Driven Index


Figure 9: Fixed Income/Convertible Arbitrage Strategies, Cumulative P/L, Actual and Pro Forma Data, Feb 1998- May 2004

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SPhinX S&P Arbitrage Index SPhinX Fixed Income Arbitrage SPhinX Convertible ArbitrageMSCI Lyxor CB Arbitrage FTSE Convertible Arbitrage HFRX Convertible Arbitrage Index

Figure 10: Global Macro Strategies, Cumulative P/L, Actual and Pro Forma Data, Feb 1998- May 2004

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SPhinX Directional/Tactical FTSE Global Macro MSCI Lyxor Global Macro SPhinX Macro HFRX Macro Index FTSE Directional


Figure 11: Managed Futures, Cumulative P/L, Actual and Pro Forma Data, Feb 1998 - May 2004

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FTSE CTA Managed Futures MSCI Lyxor CTA Managed Futures MSCI Lyxor Forex Trading SPhinX Managed Futures SPhinX S&P Managed Futures Index

Figure 12: Merger Arbitrage Strategies, Cumulative P/L, Actual and Pro Form Data, Feb 1998 - May 2004

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HFRX Merger Arbitrage Index FTSE Merger Arbitrage FTSE Equity Arbitrage SPhinX Merger Arbitrage


Figure 13: Relative Value Strategies, Cumulative P/L, Actual and Pro Forma Data, Feb 1998 - May 2004

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HFRX Relative Value Arbitrage Index FTSEhx Fixed Income Relative Value

2.2 Autocorrelations The success of any momentum trading model will ultimately be due largely to the degree to which past returns are related to future returns. For each value of time period t, Table 2 outlines the correlation in our sample of the return at time T to the return at time T-1. Note that when t is a short interval length, as in one month, the mean autocorrelation is positive and equal on average to a value of .20. In this case 35 of our 42 indices show positive serial correlations. However, when t is lengthened to six months, mean autocorrelation turns negative and the average is equal to -.05. In this case only 25 of our 42 indices show positive serial correlations. The implication of this result is that as observed by Debondt and Thaler (1985, 1989) momentum effects are only at play only in the short term as observed by in the equity markets, but that mean-reversion may be at work over longer time periods. Note also that while there is positive clustering of autocorrelations for short values of t as evidenced by a standard deviation among these indices of only .16 as compared to the greater dispersion evidenced by standard deviations of .28 and .32 respective for t=6 months and t=12 months.


Table 2: Autocorrelations Rt, Rt-1; Investable Hedge Fund Indices

Mean, Standard Deviation of Correlations - Rt, Rt-1 Key Observations:t Mean Stdev Mean autocorrelation across sample universe is positive for one month but negative for six months.

1M 0.20 0.16 Dispersion of autocorrelations increases steadily with length of measurement period2M 0.01 0.20 Certain Sectors. E.g. mgd futures, exhibit persistency in direction of serial correlations across periods6M -0.05 0.28

12M 0.00 0.32

t = 1M t = 3M t= 6M t = 12MMSCI Hedge CTA Managed Futures -0.11 MSCI Hedge Forex Trading -0.42 FTSE Hedge Convertible Arbitrage -0.58 S&P Managed Futures Index -0.50MSCI Hedge Forex Trading -0.10 MSCI Hedge LS Equity No Bias -0.31 S&P Macro -0.50 FTSE Hedge Convertible Arbitrage -0.41FTSE Hedge CTA Managed Futures -0.09 MSCI Hedge CTA Managed Futures -0.29 MSCI Hedge Forex Trading -0.44 MSCI Hedge CTA Managed Futures -0.41FTSE Hedge Global Macro -0.07 S&P Managed Futures -0.28 S&P Managed Futures -0.40 FTSE Hedge CTA Managed Futures -0.41HFR Indices Equity Market Neutral Index -0.02 S&P Directional/Tactical Index -0.26 HFR Indices Convertible Arbitrage Index -0.39 HFR Indices Event-Driven Index -0.41S&P Managed Futures -0.01 S&P Managed Futures Index -0.24 S&P Managed Futures Index -0.34 HFR Indices Distressed Securities Index -0.40S&P Managed Futures Index 0.02 FTSE Hedge Global Macro -0.24 MSCI Hedge CTA Managed Futures -0.33 MSCI Hedge Forex Trading -0.39S&P Directional/Tactical Index 0.03 S&P Macro -0.21 FTSE Hedge CTA Managed Futures -0.30 S&P Fixed Income Arbitrage -0.37S&P Macro 0.07 HFR Indices Macro Index -0.21 S&P Directional/Tactical Index -0.28 FTSE Hedge Distressed Opportunities -0.34S&P Fixed Income Arbitrage 0.10 FTSE Hedge Fixed Income Relative Value -0.18 FTSE Hedge Non-Directional -0.27 S&P Managed Futures -0.32FTSE Hedge Merger Arbitrage 0.11 FTSE Hedge CTA Managed Futures -0.16 FTSE Hedge Global Macro -0.27 HFR Indices Macro Index -0.29S&P Merger Arbitrage 0.12 FTSE Hedge Directional -0.11 MSCI Hedge LS Equity Long Bias -0.26 FTSE Hedge Equity Arbitrage -0.28FTSE Hedge Fixed Income Relative Value 0.12 FTSE Hedge Equity Hedge -0.06 FTSE Hedge Fixed Income Relative Value -0.23 FTSE Hedge Global Macro -0.28S&P Arbitrage Index 0.13 FTSE Hedge Convertible Arbitrage -0.05 HFR Indices Macro Index -0.21 S&P Event-Driven Index -0.18HFR Indices Macro Index 0.14 FTSE Hedge Index -0.04 S&P Event-Driven Index -0.21 MSCI Hedge Event Driven -0.17MSCI Hedge LS Equity Long Bias 0.15 HFR Indices Convertible Arbitrage Index -0.03 S&P Distressed -0.18 MSCI Hedge LS Equity Long Bias -0.15FTSE Hedge Directional 0.16 MSCI Hedge Global Macro -0.01 S&P Hedge Fund Index -0.12 S&P Special Situations -0.11MSCI Hedge LS Equity No Bias 0.18 FTSE Hedge Non-Directional 0.01 S&P Convertible Arbitrage -0.10 FTSE Hedge Fixed Income Relative Value -0.10HFR Indices Equity Hedge Index 0.19 HFR Indices Equity Market Neutral Index 0.02 S&P Special Situations -0.10 S&P Distressed -0.01MSCI Hedge Global Macro 0.20 S&P Fixed Income Arbitrage 0.02 HFR Indices Relative Value Arbitrage Index -0.09 FTSE Hedge Non-Directional -0.01FTSE Hedge Non-Directional 0.20 S&P Long/Short Equity 0.03 S&P Fixed Income Arbitrage -0.08 HFR Indices Relative Value Arbitrage Index 0.00S&P Long/Short Equity 0.21 MSCI Hedge Event Driven 0.04 S&P Long/Short Equity -0.06 FTSE Hedge Event Driven 0.01HFR Indices Merger Arbitrage Index 0.21 HFR Indices Relative Value Arbitrage Index 0.04 FTSE Hedge Equity Arbitrage -0.06 S&P Directional/Tactical Index 0.01FTSE Hedge Equity Arbitrage 0.22 MSCI Hedge LS Equity Long Bias 0.06 HFR Indices Distressed Securities Index -0.03 S&P Long/Short Equity 0.01S&P Market Neutral 0.24 S&P Market Neutral 0.07 FTSE Hedge Directional 0.01 HFR Indices Convertible Arbitrage Index 0.05S&P Hedge Fund Index 0.24 S&P Event-Driven Index 0.07 HFR Indices Event-Driven Index 0.02 S&P Hedge Fund Index 0.10FTSE Hedge Index 0.25 S&P Convertible Arbitrage 0.07 FTSE Hedge Index 0.02 MSCI Hedge Global Macro 0.11HFR Indices Relative Value Arbitrage Index 0.26 S&P Hedge Fund Index 0.07 MSCI Hedge LS Equity No Bias 0.03 S&P Convertible Arbitrage 0.13HFR Indices Event-Driven Index 0.30 HFR Indices Event-Driven Index 0.07 MSCI Hedge Global Macro 0.04 S&P Macro 0.16MSCI Hedge LS Equity Variable Bias 0.32 HFR Indices Equity Hedge Index 0.08 S&P Arbitrage Index 0.05 FTSE Hedge Index 0.17FTSE Hedge Equity Hedge 0.32 S&P Distressed 0.12 MSCI Hedge Event Driven 0.05 HFR Indices Equity Hedge Index 0.20FTSE Hedge Convertible Arbitrage 0.33 S&P Special Situations 0.16 S&P Market Neutral 0.12 FTSE Hedge Equity Hedge 0.26FTSE Hedge Event Driven 0.34 MSCI Hedge LS Equity Variable Bias 0.16 FTSE Hedge Distressed Opportunities 0.13 S&P Market Neutral 0.27S&P Event-Driven Index 0.35 S&P Arbitrage Index 0.16 FTSE Hedge Equity Hedge 0.13 MSCI Hedge LS Equity Variable Bias 0.27S&P Convertible Arbitrage 0.37 HFR Indices Distressed Securities Index 0.16 FTSE Hedge Event Driven 0.23 S&P Arbitrage Index 0.29FTSE Hedge Distressed Opportunities 0.37 HFR Indices Merger Arbitrage Index 0.17 HFR Indices Equity Hedge Index 0.25 FTSE Hedge Directional 0.29S&P Special Situations 0.39 FTSE Hedge Equity Arbitrage 0.21 MSCI Hedge LS Equity Variable Bias 0.28 HFR Indices Equity Market Neutral Index 0.36HFR Indices Convertible Arbitrage Index 0.41 FTSE Hedge Event Driven 0.24 MSCI Hedge CB Arbitrage 0.38 HFR Indices Merger Arbitrage Index 0.37MSCI Hedge CB Arbitrage 0.43 FTSE Hedge Distressed Opportunities 0.25 HFR Indices Merger Arbitrage Index 0.42 S&P Merger Arbitrage 0.55MSCI Hedge Event Driven 0.43 S&P Merger Arbitrage 0.31 S&P Merger Arbitrage 0.50 FTSE Hedge Merger Arbitrage 0.56S&P Distressed 0.44 FTSE Hedge Merger Arbitrage 0.39 FTSE Hedge Merger Arbitrage 0.57 MSCI Hedge LS Equity No Bias 0.64HFR Indices Distressed Securities Index 0.45 MSCI Hedge CB Arbitrage 0.57 HFR Indices Equity Market Neutral Index 0.60 MSCI Hedge CB Arbitrage 0.75Mean Autocorrelation 0.20 Mean Autocorrelation 0.01 Mean Autocorrelation -0.05 Mean Autocorrelation 0.00StDev 0.16 StDev 0.20 StDev 0.28 StDev 0.32 3. TRADING MODELS Many investments in IHFI’s carry a special caveat of required notice period for redemptions and subscriptions. Such as in the case of the HFRX funds, investments can be redeemed at month-end at NAV, subject to a notice period of 15 business days i.e. three weeks. To maintain consistency with respect to these considerations, monthly returns of various IHFI’s for the period Jan 1998 though Aug 2004 IHFI’s are sorted into five groups by provider: HFRX Certificates, HFRX Funds, MSCI Lyxor Funds, FTSEhx Funds, and SPhinX Funds. Full details with regard to trading restrictions and costs are set forth in Appendix A. This properly accounts for differences in information availability with regard to the historical returns at the time the investment decision is made. Our sample holding periods commence 1 January 2000 and end 31 December 2003, and coincide with quarter, semi-annual, and calendar year ends where applicable. We then perform out of sample tests by extending our measurement period to include available YTD returns. These include returns through 31 May 2004 for FTSEhx Funds, through 31 August 2004 for MSCI Lyxor and SPhinX Funds, and through 30 Sept 2004 for the HFRX Certificates and Funds. We compare the hypothetical experience of an investor in hedge fund investable indices under several circumstances. First we consider the investment experience of such an investor who holds an equal weighted portfolio of our IHFI universe throughout our sample holding periods. We consider this both with and without the effect of transaction and holding expenses. We next consider if this performance can be improved by using a simple momentum trading rule of holding only the funds over the subsequent holding period which have performed in the top quintile (20the percentile) of each respective group over each respective measurement period. We then test a contra/reversal strategy of holding the indices which have performed the most poorly, i.e. in the bottom quintile over the relevant measurement period. Ranking for these purposes is done on two basis, first simply on the basis of cumulative return, and second, ranking using the Rachev Ratio, (see Biglova, Jasic, Rachev & Fabozzi, 2004) to properly adjust for risk and non-Gaussian return distributions. We note however, none of these tests or criteria are sufficient to establish long term validation of results. This observation is based on the fact that underlying market behavior is, as is well known, non-stationary.


3.1 Equal Weight Buy and Hold Portfolio Before taking account for the effect of costs, investments in equal weighted portfolios of each of our sub-universe groupings would yield annualized returns over our sample period of 8.81%, 8.81%, 10.57%, 9.38% and 9.55% for HFRX Certificates, HFRX Funds, MSCI Lyxor Funds, FTSEhx Funds, and SPhinX Funds respectively, with an equal weighted portfolio of our five providers earning 9.42% over this period. With the full effect for transaction costs in the case of index certificates, and fund management and administrative fees in all cases, these returns fall to 6.35%, 7.36%, 9.05%, 8.24%, and 8.16% respectively, for an average of 7.83%. The impact of costs on returns is thus -16.90%. These results are summarized in Table 3 and graphically demonstrated in the Figures 14 through to 18. Table 3: Impact of Trading Costs and Expenses on Equal Weight Buy/Hold Portfolio of Different Investable Indices Effect of Costs on Buy/Hold Return, Full Period

Notice Required Funds Without Costs With Costs %DifferentialHFRX Certificates No Notice 8 8.81% 6.35% -27.87%HFRX Funds 0-1M Notice 8 8.81% 7.36% -16.46%MSCI Lyxor Funds 0-1M Notice 8 10.57% 9.05% -14.43%FTSEhx Funds 1-2M Notice 12 9.38% 8.24% -12.21%SPhinX Funds 2-3M Notice 14 9.55% 8.16% -14.55%Average 9.42% 7.83% -16.90% Figure 14: HFRX Certificates- Impact of Costs, Equal Weight Portfolio Jan 2000-Sept 2004

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Figure 15: HFRX Funds, Impact of Costs, Equal Weight Portfolio, Jan 2000-Sept 2004

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Figure 16: MSCI Lyxor Funds, Impact of Costs, Equal Weight Portfolio, Jan 2000-Aug 2004

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Figure 17: FTSEhx Funds, Impact of Cost, Equal Weight Portfolio, Jan 2000-May 2004

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Figure 18: SPhinX Funds, Impact of Costs, Equal Weight Portfolio, Jan 2000 - Aug 2004

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3.2 Simple Ranking Model Our first test involves the construction of simple momentum and reversal models via portfolios formed on the basis of cumulative returns through the measurement period used for portfolio formation. For consistency purposes, we consider only the returns which were known pro-forma at the time investment decisions were made. Thus for example, where a notice period of between zero and 1 months applies, T-1 monthly returns are not known at the time a decision is required, an investors will only know T-2 and prior. We then form equal weight portfolios which we reallocated respectively each 3, 6, and 12 months on the basis of ranked performance ranking over the most recent period of equal length to the holding period of which data was available. Thus for example, for a six month holding period where a one month’s notice period of up to one month applies, allocation decisions are made on the basis of ranked performance of each index over preceding 2-7 months, i.e. on the basis of performance from T-7 to T-2. For consistency and simplification, information which may have been available between prior month end and the decision cutoff point has been ignored. Indices are rebalanced at stated frequency on the basis of cumulative absolute returns which have become known in the interim holding period. For example, for those requiring 1-2 months notice and rebalanced every six months, returns used are that of the prior T-7 through T-3 months. Indices are then ranked from either lowest-highest or highest-lowest cumulative returns based whether a momentum or contra/reversal strategy is desired. From these rankings, portfolio weights are generated on the basis of their inclusion in the appropriate percentile cutoff. Thus utilizing a 20th percentile criterion will form equal weight portfolios throughout of the top or bottom 20% of performers over the prior measurement period. As fractional percentile cutoffs are not feasible, the rank cutoff points have been truncated to next lowest integer value where applicable, e.g. the 20% percentile is two indices amongst a universe of 14, and 3 indices amongst a universe of 15. Results of our tests involving a simple momentum strategy are shown below in Table 4 and Figures 19 through 28. As shown, in the absence of costs returns are highest for the HFRX Certificates, with annualized returns above 15% in all cases. This is most likely due to the benefit derived from short run positive serial correlations and is evidence, in the absence of any filtering, of some momentum effects in Investable hedge fund indices. The source of such momentum is not however known and we note in particular the report by De Souza and Gokcan (2004) who have argued that most hedge fund strategy returns display significant amounts of serial correlation due more to valuation than performance effects. To consider properly the ability for investors to earn superior returns to buy/hold strategies as well as that of actively managed fund-of-funds (HFOF’s), we must again take full consideration for all the costs involved. With regard to momentum strategies, the impact is most substantial on funds requiring no notice such as the HFRX index certificates, as an investor will incur a transaction cost each time a rebalance occurs, in addition to management and administrative fees. In most cases, however returns using this simple model appear to be superior to that of a passive buy/hold strategy. Even in the case of funds with such high fees as the HFRX Certificates, momentum effects are sufficiently strong in our sample to yield profitable results despite the effect of costs. Likely due to the presence of negative serial correlations in the data set, there are some situations in which a simple strategy of buying the poorest performers will outperform a buy and hold strategy as well before transaction costs are factored. This is most pronounced in the case of 3 month rebalancing for the MSCI Lyxor and SPhinX Funds. A summary of these Contra Model results is provided in Table 5 and the accompanying Figures 29 through 38.


Table 4: Performance Before and After Costs-Simple Momentum Model

4(a) Simple Momentum Model Without Costs Funds in Percentile Rebalance Frequency

Average Notice Required 3M 6M 12MHFRX Certificates No Notice 1 15.49% 15.38% 15.09% 16.00%HFRX Funds 0-1M Notice 1 14.42% 13.58% 14.85% 14.83%

14.86% MSCI Lyxor Funds 0-1M Notice 1 16.16% 15.21% 13.22%FTSEhx Funds 1-2M Notice 2 7.84% 10.91% 9.94% 9.56%SPhinX Funds 2-3M Notice 2 4.94% 9.07% 12.66% 8.89%Average 12.65% 11.58% 13.02% 13.33%

4(b) Simple Momentum Model With Costs Funds in Percentile Rebalance Frequency

Average Notice Required 3M 6M 12MHFRX Certific es No Notice 1 11.14% atHFRX Funds

9.52% 11.18% 12.74%0-1M Notice 1 12.90% 12.07% 13.33% 13.31%

MSCI Lyxor Funds 0-1M Notice 1 13.28% 14.57% 13.62% 11.66%FTSEhx Funds 1-2M Notice 2 6.71% 9.75% 8.79% 8.41%SPhinX Funds 2-3M Notice 2 4.20% 8.43% 9.75% 7.46%Average 10.64% 9.41% 11.26% 11.25%

Table 5: Performance Before and After Transaction Costs-Contra/Reversal Model.

5(a) Simple Contra Model Without Costs Funds in Percentile Rebalance Frequency

Notice Required Average 3M 6M 12MHFRX Certificates No Notice 1 6.70% 8.33% 6.46% 5.31%HFRX Funds 0-1M Notice 1 8.16% 8.15% 7.19% 9.14%MSCI Lyxor Funds 0-1M Notice 1 15.81% 19.52% 14.77% 13.13%FTSEhx Funds 1-2M Notice 2 6.91% 8.43% 7.22% 5.07%SPhinX Funds 2-3M Notice 2 10.45% 14.60% 9.68% 7.06%Average 9.61% 11.81% 9.06% 7.94%

5(b) Simple Contra Model With CostsFunds in Percentile Rebalance Frequency

Notice Required Average 3M 6M 12MHFRX Certificates No Notice 1 1.64% 1.30% 1.91% 1.71%HFRX Funds 0-1M Notice 1 6.72% 6.71% 5.76% 7.69%MSCI Lyxor Funds 0-1M Notice 1 14.22% 17.88% 13.19% 11.57%FTSEhx Funds 1-2M Notice 2 5.79% 7.30% 6.10% 3.97%SPhinX Funds 2-3M Notice 2 9.12% 13.51% 8.36% 5.48%Average 9.34% 7.06% 6.08% 7.49%


Figure 19: HFRX Certificates, Momentum Model Without Costs

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Figure 20: HFRX Funds, Simple Momentum Model Without Costs

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Figure 21: MSCI Lyxor Funds, Simple Momentum Model Without Costs

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Figure 22: FTSEhx Funds, Simple Momentum Model Without Costs

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Figure 23: SPhinx Funds, Simple Momentum Model Without Costs

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Figure 24: HFRX Certificates, Simple Momentum Model With Costs

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Figure 25: HFRX Funds, Simple Momentum Model With Costs

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Figure 26: MSCI Lyxor Funds, Simple Momentum Model With Costs

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Figure 27: FTSEhx Funds, Simple Momentum Model With Costs

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Figure 28: SPhinx Funds, Simple Momentum Model With Costs

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Figure 29: HFRX Certificates, Contra Model Without Costs

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Figure 30: HFRX Funds, Contra Model Without Costs

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Figure 31: MSCI Lyxor Funds, Simple Contra Model Without Costs

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Figure 32: FTSEhx Funds, Contra Model Without Costs

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Figure 33: SPhinx Funds, Contra Model Without Costs

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Figure 34: HFRX Certificates, Contra Model With Costs

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Figure 35: HFRX Funds, Contra Model With Costs

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Figure 36: MSCI Lyxor Funds, Simple Contra Model With Costs

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Figure 37: FTSEhx Funds, Contra Model With Costs

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Figure 38: SPhinx Funds, Contra Model With Costs

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3.2 Rachev Ratio Ranking Model Our second series of tests are made using portfolios formed on the basis of the Rachev Ratio as calculated over the measurement period prior to portfolio formation. Full details on the Rachev Ratio calculation and methodology are found in Biglova, Jasic, Rachev, & Fabozzi (2004). The Rachev Ratio is essentially ratio of the expected value; given a positive Value-At-Risk threshold being breached, to the expected value given a negative Value-At-Risk threshold has been breached. Estimation of the ratio can be made by taking the sample observations above a given percentile cutoff, calculating the average, and doing the same for the sample observations below a lower percentile cutoff. The Rachev Ratio is then the ratio of the two means. This methodology has the benefit of adjusting for both risk and non-normal distributions, as for example, samples which exhibit negative skew will receive lower Rachev ratios than samples emulating a normal distribution. In our tests, measurement periods cover ten monthly observations in all cases. As before however, the case where notice periods are required the most recent ten months of data which were known pro forma at the time an investment decision would be made were used. As only ten observations were used in each case, Rachev Ratios at the 90% confidence level for both positive and negative Conditional Value-At-Risk have been estimated by taking the ratio of maximum and minimum of the each sample as estimates for the 10% Conditional VaR in each case. To correct for some mathematical issues arising from cases where all observations were on the same side of zero versus others whether they were not, 100% has been subtracted from all observations prior to and for the exclusive purpose of estimating Rachev Ratios for the purposes of generating ranking. While these adjustment mean that the numbers used are not explicitly the Rachev Ratios, the rankings generated are identical to those which would be generated by an explicit calculation as would be feasible with a larger sample set. In these tests, momentum models in all scenarios in our test period fail to generate returns which are as good as a simple buy and hold strategy. A more interesting result however is observed when the Rachev methodology is applied to a Contra/Reversal strategy. Under these scenarios, significantly better returns are found amongst the MSCI Lyxor and FTSEhx Funds. The overall results for Rachev and Momentum measures ratio are provided in Table 6 and Figures 39 through 48. For the results based on Rachev ratio and Contra Model performance, these are provided on Table 7 and in Figures 49 through 58. As the practical measures involved in implementing a Rachev ratio with Contra Model investing are likely to pose considerable operational risks as regards IHFI’s, our main conclusion from these finding is that active management of investable indices is not an immediate choice.


Table 6: Rachev Momentum Model Performance With and Without Costs

6(a) Rachev Momentum Model Without Costs

Notice Required Funds in Percentile Avg 3M 6M 12MHFRX Certificates. No Notice 1 6.60% 6.60% 6.60% 6.60%HFRX Funds 0-1 Month 1 6.60% 6.60% 6.60% 6.60%MSCI Lyxor 0-1 Month 1 8.63% 8.34% 8.86% 8.70%FTSEhx Funds 1-2 Months 2 4.42% 4.47% 4.54% 4.24%SPhinX Funds 2-3 Months 2 7.59% 8.41% 7.64% 6.71%Average 6.77% 6.89% 6.85% 6.57%

6(b) Rachev Momentum Model With Costs


Table 7: Rachev Contra Model Performance With and Without Costs

7(a( Rachev Contra Model Without Costs


7(b) Rachev Contra Model With Costs



Figure 39: HFRX Index Certificates- Rachev Momentum Without Costs

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Figure 40: HFRX Funds, Rachev Momentum Without Costs

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Figure 41: MSCI Lyxor Funds, Rachev Momentum Without Costs

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Figure 42: FTSEhx Funds- Rachev Momentum Without Costs

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Figure 43: SPhinX Funds-Rachev Momentum Without Costs

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04

Cum

ulat

ive

Ret

urn


Figure 44: HFRX Index Certificates- Rachev Momentum With Costs

-5%

0%

5%

10%

15%

20%

25%

Jan-

00

Jan-

01

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02

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03

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04

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ulat

ive

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urn



Figure 45: HFRX Funds, Rachev Momentum With Costs

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

Jan-

00

Jan-

01

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02

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03

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04

Cum

ulat

ive

P/L


Figure 46: MSCI Lyxor Funds, Rachev Momentum With Costs

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

Jan-

00

Jan-

01

Jan-

02

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03

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04

Cum

ulat

ive

P/L



Figure 47: FTSEhx Funds- Rachev Momentum With Costs

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%Ja

n-00

Jan-

01

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02

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ulat

ive

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urn


Figure 48: SPhinX Funds-Rachev Momentum With Costs

0%

5%

10%

15%

20%

25%

30%

35%

40%

Jan-

00

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01

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02

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ulat

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urn



Figure 49: HFRX Index Certificates- Rachev Contra Without Costs

0%

10%

20%

30%

40%

50%

60%Ja

n-00

Jan-

01

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02

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04

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ulat

ive

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urn


Figure 50: HFRX Funds, Rachev Contra Without Costs

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Cum

ulat

ive

P/L



Figure 51: MSCI Lyxor Funds, Rachev Contra Without Costs

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

100.00%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Cum

ulat

ive

P/L


Figure 52: FTSEhx Funds- Rachev Contra Without Costs

0%

10%

20%

30%

40%

50%

60%

70%

80%

Jan-

00

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01

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02

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03

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04

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ulat

ive

Ret

urn



Figure 53: SPhinX Funds- Rachev Contra Without Costs

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%C

umul

ativ

e R

etur

n

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04


Figure 54: HFRX Index Certificates- Rachev Contra With Costs

-5%

0%

5%

10%

15%

20%

25%

30%

35%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Cum

ulat

ive

Ret

urn



Figure 55: HFRX Funds, Rachev Contra With Costs

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Cum

ulat

ive

P/L


Figure 56: MSCI Lyxor Funds, Rachev Contra With Costs

0.00%

10.00%

20.00%

30.00%

40.00%

50.00%

60.00%

70.00%

80.00%

90.00%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Cum

ulat

ive

P/L



Figure 57: FTSEhx Funds- Rachev Contra With Costs

0%

10%

20%

30%

40%

50%

60%

70%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

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04

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ulat

ive

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urn


Figure 58: SPhinX Funds- Rachev Contra With Costs

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

Jan-

00

Jan-

01

Jan-

02

Jan-

03

Jan-

04

Cum

ulat

ive

Ret

urn



4. DISCUSSION AND REMARKS For our full sample period, before taking account of costs and fees, equal weight “buy and hold” portfolios yield annualized returns of 8.81%, 8.81%, 10.57%, 9.38% and 9.55% for HFRX Certificates, HFRX Funds, MSCI Lyxor Funds, FTSEhx Funds, and SPhinX Funds respectively, with a combined portfolio of our four index groups earning an average 9.42% per annum over this period. With costs and fees these returns fall to 6.35%, 7.36%, 9.05%, 8.24%, and 8.16% respectively, for a combined portfolio average return of 7.83%. The average effect of costs is a reduction in annualized return of 16.90% (Table 3).

Despite the effect of costs, in the majority of our tests momentum effects appear sufficiently strong to suggest superior returns to a buy/hold strategy (Table 4(b)). This however may be an anomalous situation as strategies that cannot mark-to-market on the basis of published market rates may be introducing an averaging effect in their valuations. Thus we reserve our views as to whether or not any such benefits exist in practice until more data and actual investment and valuation results can be examined. The presence of some negative serial correlations in certain strategies, such as Foreign Exchange (Forex) Trading and Managed Futures, also creates some situations in which a simple strategy of buying the poorest performers will outperform a buy and hold strategy as well (Table 5(b)). Forex Trading and Managed Futures tend to have real mark-to-market valuations which are readily achieved by reference to actual month-end closing prices as posted on futures exchanges and closing market rates of the Forex inter-bank market. The negative serial correlations are what would be expected in the other strategies if they too had firm and final end of month pricings. The concern we have therefore is that if any kind of valuation averaging (or price smoothing) is being introduced then the momentum benefits may be strictly due to valuation averaging effects rather than real correlated behavior. Of necessity some strategies require this approach to month-end valuations and these must be considered in their totality before any serial correlation or momentum related effects can be firmly concluded to apply in practice.

Table 5(b) Simple Contra Model With Costs Funds in Percentile Rebalance Frequency

Notice Required 3M 6M 12M Average HFRX Certificates No Notice 1 1.30% 1.91% 1.71% 1.64% HFRX Funds 0-1M Notice 1 6.71% 5.76% 7.69% 6.72% MSCI Lyxor Funds 0-1M Notice 1 17.88% 13.19% 11.57% 14.22% FTSEhx Funds 1-2M Notice 2 7.30% 6.10% 3.97% 5.79% SPhinX Funds 2-3M Notice 2 13.51% 8.36% 5.48% 9.12% Average 9.34% 7.06% 6.08% 7.49%

Table 4(b) Simple Momentum Model With CostsFunds in Percentile Rebalance Frequency

Notice Required 3M 6M 12M Average HFRX Certificates No Notice 1 9.52% 11.18% 12.74% 11.14% HFRX Funds 0-1M Notice 1 12.07% 13.33% 13.31% 12.90% MSCI Lyxor Funds 0-1M Notice 1 14.57% 13.62% 11.66% 13.28% FTSEhx Funds 1-2M Notice 2 6.71% 9.75% 8.79% 8.41% SPhinX Funds 2-3M Notice 2 4.20% 8.43% 9.75% 7.46% Average 9.41% 11.26% 11.25% 10.64%

Table 3 Effect of Costs on Buy/Hold Return, Full Period

Notice Required Funds Without Costs With Costs %DifferentialHFRX Certific es No Notice 8 atHFRX Funds

8.81% 6.35% -27.87%0-1M Noti

MSCI Lyxor Funds ce 8 8.81% 7.36% -16.46%

0-1M Notice 8 10.57% 9.05% -14.43%FTSEhx Funds 1-2M Notice 12 9.38% 8.24% -12.21%SPhinX Funds 2-3M Notice 14 9.55% 8.16% -14.55%Average 9.42% 7.83% -16.90%


The results of our tests that employed the Rachev ratio, relative to results based on a momentum model show that after accounting for transaction costs, all scenarios considering the Rachev ratio test fail to generate returns greater than a buy and hold strategy. A more interesting result however is observed when the Rachev methodology is applied to a Contra/Reversal strategy (Table 7(b)). After transaction costs, returns in several scenarios are significantly higher than that under a buy/hold scenario. However for reasons already mentioned above these result may be anomalous as well.

In overall terms and, based on the findings of this report, investing in Investable Hedge Fund Indices is not straight forward and many unresolved issues remain. Practical considerations are foremost. Investing on a Buy and Hold basis does not appear to offer an acceptable risk/reward position relative to established HFOF’s. However, since the promoted benefit of Investable Hedge Fund Indices is to be based on Buy and Hold the findings of this report suggest that investors may not be able to actually realize the intended benefits from Buy and Hold and that are sufficiently beneficial on a risk/reward basis in practice due to the rather large discrepancies observed across the different investable indices for the same investment strategies. Introducing a Contra/Reversal strategy in practice is considered a very complex exercise as both operational and market risk issues will need complete assessments before pursuing any such efforts. Subscription and redemption notices are the biggest obstacles and appear for the most to not be any better than currently exist for investments in HFOF’s. Perhaps the wisdom should be that two things attempting to do the same thing, albeit under different names, are unlikely to improve substantially over each other.

Table 7(b) Rachev Contra Model With Costs

Notice Required Funds in Percentile 3M 6M 12M Average HFRX Certificates. 1 No Notice 3.62% 5.25% 4.76% 4.55%

1 HFRX Funds 0-1 Month 5.35% 5.91% 5.46% 5.57% 1 MSCI Lyxor 0-1 Month 12.65% 11.13% 9.44% 11.07% 2 FTSEhx Funds 1-2 Months 6.69% 8.71% 10.49% 8.63% 2 SPhinX Funds 2-3 Months 7.34% 5.55% 7.04% 6.64%

Average 7.13% 7.31% 7.44% 7.29%

Finally, the question of how well IHFI’s fare relative to Hedge FOF’s remains open. Given that there are considerable costs and fees associated with investments in IHFI’s a separate comparison would be required to justify any remarks suggesting that IHFI’s provide a more efficient or cost effective alternative to FOF’s or HFOF’s. Taking a simplified example based on the cost data presented in this report, we note there is room for considerable doubt to be cast over any absolute benefit to IHFI’s over HFOF’s (See Appendix A). Moreover, neither FOF’s nor IHFI’s have done well for investors during 2004, and with the added costs each of these have, poor performance has been exacerbated due to the multiple fee layers found in both FOF’s and IHFI’s. There is also a fairly wide degree of concern existing across the investor universe that the much touted “large capacity” promoted by IHFI’s is not as simple as it sounds. The need to find underlying managers that are good and have capacity (and plenty of it) remains highly elusive. The concern being voiced by many would be investor’s is therefore not entirely unreasonable. In simple terms that concern is, who are the managers being employed in the IHFI’s? As established FOF’s and HFOF’s already have access to the top tier managers and the capacity of these managers is not generally infinite, then what is the basis of IHFI’s for selecting the managers and capacity they have? A question we do not have any immediate answers for. If there was a completely affirmative answer, FOF’s and HFOF’s should be the biggest investors in IHFI’s, but this does not appear to be the case. We conclude by highlighting a number of recently published exchanges as to what should be a rational basis for differentiating and defining appropriate attributes for FOF’s, HFOF’s and IHFI’s. Jaeger (2004) notes that the dynamic and diverse characteristics of hedge funds bear contrast to assumptions underlying conventional index construction methods, that of homogenous underlying assets and investors who follow a “buy and hold” strategy. He demonstrates deviation between different index providers both at the broad index level and individual strategy level. He also notes that reporting biases exist which limit the usefulness of hedge fund data. Jaeger also sets out as important attributes of a good index as being:

1.) Unambiguously defined 2.) Representative 3.) Accurately measured 4.) Investable


and argues that none of these requirements can be easily fulfilled currently by IHFI’s due to lack of transparency, selection biases, lack of clear price discovery. Jaeger finally suggests IHFI’s are disguised FOF’s which capitalize on the ‘index’ moniker for marketing purposes. Zask, Bousbib and Ewing (2004) attempt to rebut the Jaeger article by writing a defense of IHFI’s. They attempt to rationalize their existence by claiming IHFI’s are vital to the industry. A chronicle of various explanations, and rationale for the shortcomings of IHFI’s is attempted. They suggest that investable indices are seen as a lower cost alternative to actively managed portfolios. They note and acknowledge imperfections with respect to the representativeness in IHFI’s. Finally, they provide an outline of compromises which must be made between competing objectives such as completeness, accuracy, transparency, investability, and low turnover. In Table 8 we attempt to highlight Jaeger’s criteria as it may be applied to different IHFI’s. Table 9 expands a number of measures applied to arrive at the results of Table 8. Table 8: Investable Hedge Fund Indices per Jaeger’s Criteria

CSFB/Tremont FTSE Hedge HFR MSCI Hedge S&P HFI

Unambiguously Defined? YES

Representative?

Accurately Measured? YES YES YES YES

Investable? YES YES YES YES YES

NO NO NO NO

NO NO NO NO NO

NO

Table 9 Rationale and attributes for different IHFI’s

CSFB/Tremont 1.) Detailed quantitative methodolgy in "CSFB/Tremont Investable Hedge Fund Index."2.) Closed funds excluded, funds with <$10mm, unaudited financials, long redemption period.3.) Fully audited financials for all underlying funds.4.) Investable through CSFB Tremont HFII Certificates.FTSE Hedge 1.) Committee decisions involved in the construction process.2.) Closed funds excluded, funds with <$50mm AUM, unaudited financials excluded.3.) Fully audited financials for all underlying funds.4.) Investable through FTSEhx funds managed by MSS Capital.HFR 1.) Lack of fully transparent methodology. 2.) Closed funds excluded, requires weekly liquidity, daily NAV's.3.) Accuracy ensured by weekly liquidity, managed account platform4.) Investable throught HFRX Tracker funds, HFRX Certificates.MSCI Hedge 1.) Subjective elements to construction process. 2.) Requires weekly liquidity, does not consider Distressed funds.3.) Accuracy ensured by weekly liquidity, managed account platform.4.) Investable through MSCI Hedge Invest Lyxor Tracker Funds.S&P HFI: 1.) Committee decisions regarding index construction criteria.2.) Excludes closed funds, multi-strategy funds. 3.) Survivorship bias and reporting bias risks; and discrepancy between "indicative" and "finalized" NAV's. 4.) Investable through SPhinX Funds.


By contrast to the above, the article by De Souza and Gokcan (2004) has argued that studies showing superior risk/return characteristics of hedge funds are misleading. They attempt to demonstrate that most hedge fund strategy returns display significant amounts of serial correlation. This is strongest in convertible arbitrage and distressed securities. This has the effect of creating a smoothing effect and understating volatility. De Souza and Gokcan propose a statistical technique to eliminate serial correlations and discover the true return distribution of hedge fund strategy returns. They note that, given the extent of the changes in volatility and the shift in the efficient frontier, the uncorrected use of hedge fund data in the portfolio construction process will significantly understate risk and create systematic, but unwarranted allocation biases. 5. CONCLUSIONS We conclude by noting the following key remarks and observations:

1. Investigation of Investable Hedge Fund Indices (IHFI’s) suggests that much remains to be answered with respect to the viability of these as replacements of or alternatives to HFOF’s. While the appeal of an ‘index’ nature is high, the limitations and practical restrictions of investing in these parallel many of the same restrictions and liquidity features of FOF’s and HFOF’s

2. The proposal of IHFI’s of offering increased capacity and general scalability remains at odds with the

observation that if existing and well established FOF’s and HFOF’s have already gained access to leading managers and their capacity then were is the proposed increased capacity coming from for the IHFI’s?

3. A comparison of the same Hedge Fund investment strategies or styles across the different IHFI’s considered shows non-uniformity across the board as far as the performance, risk and risk/return characteristics. The causes for these discrepancies appear to be due to more than statistical differences. There are different fees and costs, different approaches to manager selection, and the general observation which confirms that equal risks are not being provided with equal rewards.

4. A number of suggestions have been made by some industry practitioners as what would constitute important attributes for a good index product. Based on these recommendations none of the IHFI’s reviewed in this report comply with all of the requirements stipulated. A risk therefore remains that by referring to IHFI’s as an ‘index’ type product that there is an assumption of strict adherence to what is more commonly known as or accepted to be an index, such as a stock market index. We therefore prefer to think of IHFI’s as a competing choice for HFOF’s of FOF’s type of investments.

5. While there are practical limitations as to the monthly valuation of many Hedge Fund styles of investing, these

need proper accountability before assumptions are made as to whether there is ‘momentum’ of maintained serial correlation for certain Hedge Fund index performance. There is more likely to be valuation smoothing or averaging contributing to any measured levels of serial correlation than actual correlation. Methods to account for these effects have been proposed and should be considered as a necessary step in devising any analysis or allocations amongst Hedge Fund strategies whether in terms of independent strategies or IHFI’s.

In closing, we note that there remain many opportunities for the use of IHFI’s but at the moment they are hard to distinguish from more established vehicles of FOF’s or HFOF’s. The challenges are as much to investors as to the index providers themselves. If the ability to short these IHFI’s were to be made available (as exists for more conventional market indices) the current spread of discrepancies amongst the same or similar Hedge Fund styles being provided by the different IHFI’s would invite arbitrage trading across the same styles by different providers. It would be an arbitrage of managers in fact. This would most likely lead to the very opposite effect desired of a stable investment instrument where the belief that buy and hold should set the stage. Which then begs the question, should we not just stick to market indices and the HFOF’s and FOF’s that actively manage the managers that manage the market indices? We will all no doubt know the answer to this and many similar questions in the not too distant future.


App

e


ndix

A.

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Indi

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Cos

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t of t

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No

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e V

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r Arb

itrag

e In

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tific

ate

(SW

X L

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on

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0%2.

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Neg

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ble

No

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tress

ed S

ecur

ities

Inde

x C

ertif

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e H

FRX

(SW

X L

iste

d)co

ntin

uous

on

SW

Xno

ne1.

40%

0.00

%10

0%2.

00%

Neg

otia

ble

No

Eve

nt-D

riven

Inde

x C

ertif

icat

e H

FRX

(SW

X L

iste

d)co

ntin

uous

on

SW

Xno

ne1.

40%

0.00

%10

0%2.

00%

Neg

otia

ble

No

EH

FRX

quity

Hed

ge In

dex

Cer

tific

ate

(SW

X L

iste

d)co

ntin

uous

on

SW

Xno

ne1.

40%

0.00

%10

0%2.

00%

Neg

otia

ble

No

Equ

ity M

arke

t Neu

tral I

ndex

Cer

tific

ate

(SW

X L

iste

d)co

ntin

uous

on

SW

Xno

ne1.

40%

0.00

%10

0%2.

00%

Neg

otia

ble

No

Hed

HFR

XM

SC

Ige

Inve

st L

yxor

Tra

cker

Fun

d Lt

dW

eekl

y1

wee

k0.

00%

0.00

%10

0%1.

50%

(9)

No

Hed

MS

CI

ge In

vest

Lyx

or 4

X T

rack

er F

und

Ltd

Wee

kly

1 w

eek

0.00

%0.

00%

100%

(10)

3.88

%(1

1)N

o G

loba

l Mac

ro L

MS

CI

yxor

Tra

cker

Fun

d Lt

dW

eekl

y 1

wee

k0.

00%

0.00

%10

0%1.

40%

No

EM

SC

Iqu

ity L

ong

Bia

s Ly

xor T

rack

er F

und

Ltd

Wee

kly

1 w

eek

0.00

%0.

00%

100%

1.40

%N

o E

MS

CI

quity

No

Bia

s Ly

xor T

rack

er F

und

Ltd

Wee

kly

1 w

eek

0.00

%0.

00%

100%

1.40

%N

o E

MS

CI

quity

Var

iabl

e B

ias

Wee

kly

1 w

eek

0.00

%0.

00%

100%

1.40

%N

o M

ana

MS

CI

ged

Futu

res

Lyxo

r Tra

cker

Fun

d Lt

dW

eekl

y 1

wee

k0.

00%

0.00

%10

0%1.

40%

No

For

ex T

radi

nM

SC

Ig

Lyxo

r Tra

cker

Fun

d Lt

dW

eekl

y 1

wee

k0.

00%

0.00

%10

0%1.

40%

No

CB

Arb

itra

MS

CI

ge L

yxor

Tra

cker

Fun

d Lt

dW

eekl

y 1

wee

k0.

00%

0.00

%10

0%1.

40%

No

Eve

nt D

riven

Lyx

or T

rack

er F

und

Ltd

Wee

kly

1 w

eek

0.00

%0.

00%

100%

1.40

%N

oX

Ful

l Exp

osur

equ

arte

rly

65 d

ays

0.00

%0.

00%

100%

1.50

%N

oX

Eve

nt-D

riven

qu

arte

rly (1

2)65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

nX D

istre

ssed

quar

terly

65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

nX M

erge

r Arb

itrag

equ

arte

rly

65 d

ays

0.00

%0.

00%

100%

1.50

%N

egot

iabl

eN

onX

Spe

cial

Situ

atio

nsqu

arte

rly

65 d

ays

0.00

%0.

00%

100%

1.50

%N

egot

iabl

eN

oX

Dire

ctio

nal/T

actic

al

quar

terly

65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

nX M

acro

quar

terly

65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

nX E

quity

Hed

gequ

arte

rly

65 d

ays

0.00

%0.

00%

100%

1.50

%N

egot

iabl

eN

onX

Man

aged

Fut

ures

quar

terly

65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

X A

rbitr

age

quar

terly

65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

X E

quity

Mar

ket N

eutra

lqu

arte

rly

65 d

ays

0.00

%0.

00%

100%

1.50

%N

egot

iabl

eN

oX

Con

verti

ble

Arb

itrag

equ

arte

rly

65 d

ays

0.00

%0.

00%

100%

1.50

%N

egot

iabl

eN

oX

Fix

ed In

com

e A

rbitr

age

quar

terly

65

day

s0.

00%

0.00

%10

0%1.

50%

Neg

otia

ble

No

arbu

rg S

&P

Hed

ge F

und

Inde

x C

ertif

icat

esqu

arte

rly a

t NA

V, d

aily

v. b

id-o

ffer s

prea

MS

CI

SP

hin

SP

hin

Sph

iS

phi

Sph

iS

Phi

nS

phi

Sph

iS

phi

SP

hin

SP

hin

SP

hin

SP

hin

UB

S W

d65

days

for N

AV

1.00

%(1

3)0.

00%

100%

1.27

%(1

4)N

egot

iabl

eN

o

SP

DR

Tru

st (S

PY)

cont

inuo

us

none

0.04

%(1

5)0.

04%

50%

(16)

0.01

%(1

7)Ye

sN

AS

DA

Q 1

00 T

rack

ing

Trus

t (Q

QQ

)co

ntin

uous

no

ne0.

05%

0.05

%50

%0.

20%

(18)

Yes

BU

Y C

OST

FUN

DIN

G C

OST

Per A

nnum

Ex

pens

es

App

endi

x A

. (co

nt'd

.) Ta

ble

A-1

Not

es:

(1) P

er C

SFB

, con

tinou

s O

TC tr

adin

g is

ava

ilabl

e su

bjec

t to

bid-

ask

spre

ad.

(2) P

er C

SFB

, tot

al c

ost s

truct

ure

is 1

.4%

(3) R

efle

cts

1/2

curr

ent b

id-o

ffer s

prea

d of

1.4

% o

n S

WX

. per

Sw

iss

Exc

hang

e m

ax s

prea

d is

2%

for b

road

indi

ces

and

3% fo

r ind

ivid

ual s

trate

gy in

dice

s fo

r up

to C

HF

2000

00M

ax s

prea

d ca

n be

wai

ved

in e

xcep

tiona

l circ

umst

ance

s, e

.g.

LTC

M-ty

pe b

low

-up,

at d

iscr

etio

n of

exc

hang

e on

a re

ason

able

requ

est b

y th

e m

arke

t mak

er.

Ther

e is

no

requ

irem

ent b

y ex

chan

ge th

at q

uote

s ar

e bo

und

to N

AV

in a

ny w

ay n

or is

this

pos

sibl

e.

(4) P

er H

FR, m

ore

frequ

ent t

radi

ng is

ava

ilabl

e at

add

ition

al c

ost.

Rol

ling

out p

latfo

rm s

hortl

y w

hich

will

allo

w fo

r par

tial w

eekl

y liq

uidi

ty.

(5) P

er H

FR tr

adin

g is

NA

V-N

AV

for s

ubsc

riptio

ns, r

edem

ptio

ns, a

nd re

allo

catio

ns (6

) Per

HFR

, can

be

nego

tiate

d as

low

as

.35%

ann

ually

for i

nves

tmen

ts o

f US

D 5

0M, a

nd a

rate

som

ewhe

rebe

twee

n w

ould

app

ly fo

r pla

nned

inve

stm

ent b

etw

een

US

D 1

and

50M

. 13

5bps

ass

umes

no

such

inve

stm

ent

leve

l has

bee

n ag

reed

. N

egot

iate

d ra

tes

wou

ld a

pply

from

dol

lar o

ne, b

ut w

ould

be

rene

gotia

ted

(but

not

retro

activ

ely)

six

mon

ths

henc

e if

inve

stm

ent l

evel

s fa

iled

to re

ach

thos

e ag

reed

.

(7) R

efle

cts

1/2

of c

urre

nt 1

.2%

Dre

sdne

r bid

offe

r spr

ead

on S

WX

. Per

mem

oran

dum

will

mai

ntai

n sp

read

of +

/- 1%

to N

AV

as

is c

alcu

late

d da

ilype

r Dre

sdne

r will

hon

or m

ax 2

% s

prea

d up

to U

SD

10M

M

(8) R

efle

cts

"rep

licat

ion

fee"

of 2

% p

er y

ear.P

er D

RK

W, w

ill re

bate

dow

n to

1%

for a

gree

d in

vest

men

t lev

els

in th

e U

SD

10M

+ ra

n ge

and

wou

ld a

pply

from

dol

lar o

ne in

vest

ed.

(9) P

er S

ocG

en, c

ost s

truct

ures

is .5

5% m

gmt f

ee fo

r bro

ad in

dex

and

.45%

for s

ubin

dice

s +

.95%

at i

ndex

leve

l on

both

(10)

Inve

stm

ent r

equi

res

100%

inve

stor

cap

ital,

how

ever

stru

ctur

e em

ulat

es b

ehav

ior o

f 25%

equ

ity w

ith c

olla

r cap

ping

ups

ide

at 6

X in

itial

and

dow

nsid

e to

val

ue o

f inv

estm

ent

(11)

Incl

udes

fund

ing

cost

of L

ibor

+ 1

00bp

s es

timat

ed a

t cur

rent

3m

onth

Lib

or o

f 1.9

1% o

n 75

% o

f ini

tial i

nves

tmen

t. ad

ditio

nally

incl

udes

20b

ps "s

et u

p" fe

e w

hich

app

lies

only

in th

e fir

st y

ear o

f the

cer

tific

ate'

s lif

e

(12)

Per

Plu

sFun

ds, m

onth

ly li

quid

ity m

ay b

e po

ssib

le o

n su

bsec

tor s

trate

gies

(13)

Per

UB

S, c

an e

xpec

t 1%

bid

-offe

r spr

ead,

how

ever

pos

sibl

y ne

gotia

te d

own

to 2

5bps

wid

e af

ter 6

-9m

onth

s de

alin

g

(14)

Per

UB

S, 7

5bps

of .

5% q

uarte

rly c

ertif

icat

e fe

e w

ill b

e "r

edis

tribu

ted.

" Cal

cula

tion

assu

mes

redi

strib

utio

n is

mad

e at

yea

r-en

dca

lcul

atio

n is

ther

efor

e 10

0000

0*((

1.00

5^4-

1)-.0

075)

(15)

Ref

lect

s 1/

2 of

cur

rent

AM

EX

bid

-offe

r spr

ead

of .0

0897

% a

nd J

FM n

egot

iate

d eq

uity

com

mis

ion

rate

of .

035%

(16)

Per

US

Fed

eral

Res

erve

Reg

ulat

ion

'T'

Eur

opea

n pr

ime

brok

ers

may

offe

r mor

e le

nien

t ter

ms.

(17)

Per

SP

Y pr

ospe

ctus

(18)

per

AM

EX

web

site


REFERENCES Biglova, B., Jašić, T., Rachev, S. and Frank J. Fabozzi, F.J., (2004), “Profitability of momentum strategies: Application of novel risk/return ratio stock selection criteria”, private communications De Souza C., and Gokcan, S. (2004), “Hedge Fund Volatility: It’s Not What You Think It Is”, AIMA Journal, September 2004, No. 63, Pages 20-22 Debondt, W.F.M. and Richard H. Thaler, R.H., (1989), “Anomalies: A Mean-Reverting Walk Down Wall Street” The Journal of Economic Perspectives, Vol. 3, No. 1 (Winter 1989), 189-202 Debondt, W.F.M. and Richard H. Thaler, R.H. (1986), “Further Evidence on Investor Overreaction and Stock Market Seasonality” The Journal of Finance, Vol. 42, No. 3, Papers and Proceedings of the Forty-Fifth Annual Meeting of the American Finance Association, New Orleans, Louisiana, December 28-30, 1986, 557-581 Debondt, W.F.M. and Richard H. Thaler, R.H., (1985), “Does the Stock Market Overreact?” The Journal of Finance, Vol. 40, No. 3, Papers and Proceedings of the Forty-Third Annual Meeting American Finance Association, Dallas, Texas, December 28-30, 1984 (Jul., 1985), 793-805 Jaeger, L. (2004), “Hedge Fund Indices: A New Way to Invest in Absolute Return Strategies?” AIMA Journal, June 2004, Pages 23-26

Zask, E., Gabriel Bousbib, G. and Ewing, P. (2004), PlusFunds “Can the Hedge Fund Industry Mature Without Investable Indices?” AIMA Journal, September 2004, Pages 18-20

Disclaimer: This publication has been prepared by Jacobson Fund Managers Ltd (‘Jacobson’) and is provided to you for information purposes only. The information contained in this publication has been obtained from sources that Jacobson believes are reliable but we do not represent or warrant that it is accurate or complete. The views in this publication are those of Jacobson and are subject to change, and Jacobson has no obligation to update its opinions or the information in this publication. Neither Jacobson, nor any affiliate, nor any of their respective officers, directors, partners, or employees accepts any liability whatsoever for any direct or consequential loss arising from any use of this publication or its contents. The IHFI’s discussed in this publication may not be suitable for all investors. Jacobson recommends that investors independently evaluate each one discussed in this publication and consult any independent advisors they believe necessary. This communication is being made available in the UK and Europe to persons who are investment professionals as that term is defined in Article 19 of the Financial Services and Markets Act 2000 (Financial Promotion Order) 2001. It is directed at persons who have professional experience in matters relating to investments. The investments to which it relates are available only to such persons and will be entered only with such persons. Notwithstanding, nothing whatsoever in this communication is intended to, nor is it in any manner an invitation or any solicitation to invest with Jacobson. Jacobson is authorised and regulated by the Financial Services Authority (‘FSA’).


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