HEDGE FUND PURISTS argue that indices run counter to the entire concept of generating risk-adjusted absolute returns through active investment management, and frequently dismiss indices as a gimmick used as a marketing tool to attract new investors. Investable index providers claim that they can offer the benefits of a diversified fund of hedge funds at a substantially lower cost, with more transparency and higher liquidity.
The truth lies somewhere in between. To understand the role investable indices might play in an investor's portfolio and their strengths and weaknesses, it is important to understand how the indices function.
More than 20 non-investable hedge fund indices have emerged since 1987. The first hedge fund indices lumped the performance data from all hedge funds in the same pot. Although these broad-based indices provided some idea of overall hedge fund performance, they masked the diversity of individual funds' risk/return characteristics. As the industry grew, it became increasingly important to separate the different hedge fund strategies and styles, and style-specific indices were created. However, at best a hedge fund index can depict the mean of performance across hedge funds and can therefore only provide an indication of general performance within the industry or a particular style.