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Alternative Market Briefing

Other Voices: Misuse and use of hedge fund indices

Thursday, June 03, 2010

Article authored by François Duc, Risk Advisory, UBP Alternative Investments.

Status Review In contrast to the regulated world of traditional investments, the hedge-fund universe cannot be fully encompassed. Hedge funds are private structures, devoid of any regulatory obligations to disclose the returns they generate. The only access to relevant information is provided by the various commercial databases available. However, these databases' representation of the hedge-fund universe is significantly distorted: hedge-fund managers only contribute to these databases voluntarily. Moreover, each database has a significant way to go in order to cover a sufficiently large part of the universe.

Small samples obtained by means of a non-random drawing process and extracted from a heterogeneous population lead to a significantly biased representation. Hedge-fund indices are built using these databases and therefore inherit their shortcomings. If one is to believe that hedge-fund indices estimate the average return of the total, the hedge-fund universe is thus illusory. In fact, in indices it is impossible to separate out returns from fluctuations on the hedge-fund market and the variation due to discrepancies in index construction. The latter is particularly important, as the heterogeneity of hedge funds indices reveals.

Indeed, two indices which aim to represent the same strategy can betray monthly-return differentials of more than 1,400 basis points (bp). O......................

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