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By Donald A. Steinbrugge, CFA, Founder and CEO - Agecroft Partners, LLC

Although hedge fund indices can be a very useful tool, indices can also create confusion if their construction and composition are not well understood. Take for example hedge fund industry performance: what does this number represent? The hedge fund industry is not an asset class, rather, it is a fund structure that may be used in a broad array of strategies. It is like calculating the performance of the mutual fund industry into a single number by combining the performance of money market funds, bond funds and equity funds. In addition, in any given month, one hedge fund index could report positive performance for the industry while another could be negative. Reporting discrepancies also affect industry information such as total number of hedge funds, total industry assets as well as performance reporting for individual strategies. These inconsistencies are the result of three different ways hedge funds indices are constructed and differing universes of hedge funds that participate in each index. 

The 3 different ways hedge fund indices are constructed:

Equally weighted. For an equally weighted index, the performance of each fund included carries the same importance regardless of fund size. Performance is calculated based on the average performance of all funds included in the index. This structure best reflects the performance of the average hedge fund globally.  

Asset weighted. For an asset weighted index, weight in the index is distributed based on the asset size of a hedge fund, where a $10 billion hedge fund will have a hundred times the weighting of a $100 million fund. This leads to the index performance being dominated by the largest funds and more closely reflects the performance of all assets invested in hedge funds. Since small and mid-sized hedge funds have outperformed large hedge funds over time, this structure tends to underestimate the performance of the average hedge fund.  

Investible hedge fund Indices. Investible hedge fund indices typically include a daily NAV. In order to create these daily valuations, the index company creates managed accounts of managers from a subset of the broader industry. There is some adverse selection, because a number of managers do not want to participate in these indices for various reasons. In addition, these managed accounts typically do not run pari passu with the main hedge fund, because they do not include less liquid securities.   

Following the Madoff fraud, these liquid indices have become more popular because of their greater transparency, liquidity and the independent custodial and administration of the fund. The media also likes to use these indices to report industry performance, because of the timeliness of data. Although there are many positives to investible indices, many have significantly underperformed in comparison to more traditional hedge fund indices over time. This is most likely due to a combination of the omission of less liquid securities, which often contain greater inefficiencies and expected returns, along with the additional administrative costs allocated to the fund for running these structures.   

Unlike indices of the equity market, (S&P 500, the Dow Jones Industrial Average, EAFA), hedge fund indices are completely voluntary and information on performance must be submitted by the manager on a monthly basis. Due to the voluntary nature of information gathering, many of the top hedge funds, along with hedge funds that have recently closed to new investors and many underperforming hedge funds will not report their data. There are also a lot of managers that don't want to participate in indices for confidentiality reasons or they don't want to spend the time and effort of submitting their data. We estimate that approximately 50% of hedge funds do not report their performance to any hedge fund indices. In addition, most of the hedge funds that do participate in databases do not report their information to all indices.  

The negatives with hedge fund indices include:  

1. Hedge fund aggregate industry performance is not very useful and there is a wide disparity in hedge fund industry performance across indices. 
2. Aggregate information, in regards to industry assets and number of hedge funds are under reported because only a portion of the market is captured. 
3. Performance relative to individual strategies can vastly differ across various hedge fund indices. This is due to varying manager participation rates, but more importantly, the lack of an industry standard for categorization. Two separate index companies can label managers in two completely different strategies. 

1. Hedge fund indices do a great job of reporting hedge fund industry trends in assets under management and numbers of hedge funds over time, as long as the same index is used.
2. Investible indices are a great tool to get an approximation of strategy performance intra month. 
3. Strategy level performance data can be useful as a benchmark with which to compare individual hedge funds, provided the fund definitions and composition of the index are clearly understood. With that said, investors should fully expect a high quality hedge fund to outperform the strategy index by a wide margin. There are low barriers of entry to the hedge fund industry, and a vast majority of funds are of poor quality.