As the trend to investing in absolute returns strategies continues, as part of the toward a new style of asset allocation, so too is the need for new or customised benchmarks increasing. The time must have come for the industry to question whether it is satisfactory any longer to benchmark a complex hedge fund strategy, for instance, against cash.
Cash is often described as the ‘riskfree rate’. It is difficult to imagine why any investment other than something approaching ‘no risk’ should have the ‘risk-free rate’ as its benchmark. Of course, many managers will argue that their funds are genuine ‘absolute returns funds’ – that they are ‘benchmark unaware’. But are they really? Every competitive endeavour needs to be measured against something, even if it is only the performer’s peers. Inevitably a funds manager, like a sportsperson, will at least look over his or her shoulder at some stage of the race.
When you throw two other overlapping trends into the mix – the search for alpha, and subsequent issues with defining it, and the payment of performance fees – then the questions about benchmarks become especially important. The phenomenon of ‘hedge fund beta’ is at last gaining recognition. As described by Cliff Asness, the founder of AQR Capital in the US, hedge fund beta refers to that added value which is derived from the systematic exploitation of an investment factor. For instance, an event-arbitrage fund will invest in takeover situations, attempting to exploit mispricings in the process. It will correlate only lowly with the market beta, and will therefore be benchmarked against something else, often cash.
But, it has been discovered, a simple strategy of buying every target stock immediately after the takeover is announced and selling the acquiring stock will make money over time. So, the true beta, and better benchmark, of the event-arbitrage manager is this simple strategy of buying the target and selling the acquirer.
Asness argues that investors should be prepared to pay more for hedge fund beta than market beta, but not as much as they should pay for true alpha. So, the need for a wide range of better benchmarks Standard & Poor’s, the world’s largest index provider, is doing its best to keep up with the theoretical demand for customised and new indices against which to measure the proliferation of investment strategies. But this is not easy.
On a visit to Australia last month, Christopher O’Brien, S&P’s Parisbased vice president for index and portfolio services, said the custom indices business was large and growing globally but the major users were managers rather than their clients. The indices were more often being used to create investment products than measure the performance of existing products. Coincidentally, S&P last month launched a family of arbitrage indices in the US, including a merger arbitrage index.