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.
The company also provides in the US an S&P 500 130:30 index, based on which State Street Global Advisors has launched an exchange traded fund, and an S&P 500 short index. The first of the arbitrage indices are: the S&P 500 Volatility Arbitrage Index; the S&P Currency Arbitrage Index; and the S&P Long-Only Merger Arbitrage Index. More arbitrage indices are expected later this year.
The volatility index models a strategy which takes advantage of the difference between implied volatility and realised volatility. The index receives implied variance and pays realised variance of the S&P 500. The volatility investment strategies are based on the tendency for implied volatility of an asset to be higher than realised volatility. The currency arbitrage index models a strategy based on the G10 currencies, taking a long position in currencies which have a higher interest rate than the US dollar and a short position in currencies with a lower interest rate than the US dollar.
The weight of each currency is directly proportional to its interest rate spread and inversely proportional to its volatility. The merger arbitrage index models a strategy which exploits various commonly observed price changes associated with mergers. The index is comprised of long positions in up to 40 large and liquid stocks that are active targets in pending merger deals. A target company is considered for inclusion if at least 25 per cent of the bid is to be paid in cash.
Deals are screened on the basis of size, liquidity, premium and exchange listing to ensure the underlying positions are tradable and that there is upside potential if the deals close. In November last year, S&P announced it would launch three USbased credit default swap indices in the first quarter of this year. While these are not customised indices their development is a big step forward for investors aiming to judge the performance of new and sophisticated strategies by their managers, and therefore make more informed decisions on what constitutes skill and how its should be remunerated.
The index management versus active management debate, which has raged for more than 20 years, continues. Even for investors who believe they can pick managers who can beat their benchmarks consistently, a better understanding of those benchmarks will improve their governance procedures and help keep managers honest with their fees.