As it has become clear that hedge fund indices hardly provide a strong representation of single funds, we may ask the question: Why should this matter? How could the pitfalls and drawbacks of the index methodology affect the due diligence practice? The two following points explain this problem.
First, using indices as benchmarks of hedge fund performance likely results in collating two uncorrelated (or low correlated) asset classes. The common practice of hedge fund assessment implies comparing various fund performance attributes with those of a corresponding index. Typically, it includes returns, risk statistics (the VaR or the standard deviation), a number of positive months, largest drawdowns, time-under-water and so on. Next, that comparison leads to a conclusion whether the fund outperforms or underperforms the related index. However, if the index is poorly linked with the fund, i.e. exhibits a low representativity, the entire analysis makes little sense.
Second, fully relying on index analysis, we disregard key factors driving the fund’s performance. In other words, there could be various groups of factors better correlated with the fund and, consequently, providing a deeper insight into the fund’s behavior. However, identifying those factors requires applying advanced techniques of the multiple regression or Principal Components analyses, which are not so simple.
Unfortunately, in practice, the described problems are hardly ever taken into account. Applying the naive and simplistic approach of comparing fund performance against uncorrelated indices, we ignore one of the main aspects of the alternative investment industry - alpha generation. Driven by the incentive fees, hedge fund managers aim to produce absolute returns rather than beating the index. This contrasts drastically with traditional mutual fund managers. Therefore, hedge funds, by their nature, tend to deliver returns that would unlikely follow the related strategy index. In turn, this makes a due diligence task even more complicated, because requires the deep investigation of the real driving forces behind the strategy label.
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