You’d be forgiven for not immediately associating investment benchmarks with Japanese warriors. But SAMURAI is the CFA Institute’s acronym for a benchmark’s key qualities. These are specified in advance; appropriate; measurable; unambiguous; reflective of current investment opinion; accountable; and investable.
For institutional investors looking to allocate to hedge funds, the ‘I’ in SAMURAI matters most of all. The lack of high-quality investable benchmarks has long been a problem here. Many institutional investors want a hedge-fund allocation, with a typical target allocation of 8–10% of the total portfolio. But a great many are currently under-allocated. We estimate that as much as $200 billion of US pension funds are earmarked for investment in alternatives, but are sitting on the sidelines for now.
Many institutional investors want a hedge-fund allocation, with a typical target allocation of 8–10% of the total portfolio.
Why is this? Various factors are at play here, but the main ones are complexity, time and cost.
Complexity arises because the dispersion of returns in the hedge-fund universe is so wide. Or, to put it another way, some hedge funds perform very well while some perform very badly. At different times, many do both. If you can get your choice and timing right, then great; if you can’t, then things can go very wrong. Understandably, many investors struggle with this aspect.
Time constraints are important too. Because this market is so varied, complex and uncertain, investment committees and fund boards often spend too much of their time agonising over potential investments and the performance of their existing holdings with a disproportionate amount of time being spent at board meetings debating a relatively modest hedge-fund allocation.
Then there’s cost. Here, investors usually face a binary choice: pick the funds themselves (which usually requires a large internal team) or to pay someone else to do it. Either way, fund selection entails meaningful costs, whether internal or external, which then need to be justified through the delivery of investors’ return objectives.
That’s why the market is crying out for investable hedge-fund indices that enable passive allocations to the hedge-fund universe without excessive costs. Until recently, however, passive hedge-fund investment has only been available through hedge-fund replication funds. These estimate hedge-fund exposure using liquid proxies and backward-looking techniques that result in high tracking errors and can have higher correlations to conventional asset classes.
But that is changing. Index providers are beginning to offer benchmarks that fit the SAMURAI criteria. These new indices avoid the survivorship bias and other calculation biases that dog their backward-looking predecessors. And, most importantly, they put the ‘I’ in SAMURAI by being fully replicable and investable. By far the most accurate way to replicate an index return is to physically invest in the underlying constituents. So the emergence of investable hedge-fund indices offers investors the revolutionary prospect of genuine hedge-fund beta.
This should open the hedge-fund market to the passive revolution that has swept through other asset classes. It’s a revolution that has been far-reaching and transformative. Morningstar recently reported that US assets in tracker funds now outweigh those in funds run by stock-pickers. And the trend looks to have much further to run.
There are downsides to passive strategies, of course. By buying the benchmark, institutional investors are forgoing the chance of excess returns or ‘alpha’. These are often seen as one of the main attractions of hedge funds. But trading alpha for beta has considerable merits. Hedge-fund alpha is elusive and often inconsistent; if you succeed in picking one year’s winner, there’s no guarantee that it won’t be next year’s loser. So, by buying the benchmark, you allow the positive and negative tails to net out, so that you to enjoy the other benefits of hedge-fund investing.
Those benefits are significant. The hedge-fund universe offers low correlation to traditional asset classes, the potential for enhanced returns (through absolute-return strategies and the use of leverage) and considerable scope for risk reduction. So there’s a very strong argument for forgetting about chasing the tails and simply seeking the aggregate attractions of the asset class. For many fund boards, this will enable them to concentrate on asset classes where their fund-selection skills will be more effective.
And for those with the requisite expertise in fund selection, investable indices will enable them to focus on a few alpha-generating candidates while balancing the associated risks by allotting the rest of their hedge-fund budget to the benchmark.
We can draw a parallel here with equity allocations. Just as a board might decide to keep its US equity allocation entirely in index-tracking funds while using a high-alpha manager for emerging markets, so they might choose to keep 60% of their hedge-fund allocation in the index while allocating 40% to hand-picked, high-alpha managers. The passive revolution is likely to be just as transformative in the hedge-fund universe as it has been elsewhere. Investable hedge-fund indices offer investors huge benefits through greater convenience and reduced costs. And, given the attractions of hedge-fund beta, those who take advantage of these new SAMURAI indices can hope to give their portfolios a real cutting edge.
Complexity arises because the dispersion of returns in the hedge-fund universe is so wide. Or, to put it another way, some hedge funds perform very well while some perform very badly. At different times, many do both. If you can get your choice and timing right, then great; if you can’t, then things can go very wrong. Understandably, many investors struggle with this aspect.
Time constraints are important too. Because this market is so varied, complex and uncertain, investment committees and fund boards often spend too much of their time agonising over potential investments and the performance of their existing holdings with a disproportionate amount of time being spent at board meetings debating a relatively modest hedge-fund allocation.
Then there’s cost. Here, investors usually face a binary choice: pick the funds themselves (which usually requires a large internal team) or to pay someone else to do it. Either way, fund selection entails meaningful costs, whether internal or external, which then need to be justified through the delivery of investors’ return objectives.
That’s why the market is crying out for investable hedge-fund indices that enable passive allocations to the hedge-fund universe without excessive costs. Until recently, however, passive hedge-fund investment has only been available through hedge-fund replication funds. These estimate hedge-fund exposure using liquid proxies and backward-looking techniques that result in high tracking errors and can have higher correlations to conventional asset classes.
But that is changing. Index providers are beginning to offer benchmarks that fit the SAMURAI criteria. These new indices avoid the survivorship bias and other calculation biases that dog their backward-looking predecessors. And, most importantly, they put the ‘I’ in SAMURAI by being fully replicable and investable. By far the most accurate way to replicate an index return is to physically invest in the underlying constituents. So the emergence of investable hedge-fund indices offers investors the revolutionary prospect of genuine hedge-fund beta.
This should open the hedge-fund market to the passive revolution that has swept through other asset classes. It’s a revolution that has been far-reaching and transformative. Morningstar recently reported that US assets in tracker funds now outweigh those in funds run by stock-pickers. And the trend looks to have much further to run.
There are downsides to passive strategies, of course. By buying the benchmark, institutional investors are forgoing the chance of excess returns or ‘alpha’. These are often seen as one of the main attractions of hedge funds. But trading alpha for beta has considerable merits. Hedge-fund alpha is elusive and often inconsistent; if you succeed in picking one year’s winner, there’s no guarantee that it won’t be next year’s loser. So, by buying the benchmark, you allow the positive and negative tails to net out, so that you to enjoy the other benefits of hedge-fund investing.
Those benefits are significant. The hedge-fund universe offers low correlation to traditional asset classes, the potential for enhanced returns (through absolute-return strategies and the use of leverage) and considerable scope for risk reduction. So there’s a very strong argument for forgetting about chasing the tails and simply seeking the aggregate attractions of the asset class. For many fund boards, this will enable them to concentrate on asset classes where their fund-selection skills will be more effective.
And for those with the requisite expertise in fund selection, investable indices will enable them to focus on a few alpha-generating candidates while balancing the associated risks by allotting the rest of their hedge-fund budget to the benchmark.
We can draw a parallel here with equity allocations. Just as a board might decide to keep its US equity allocation entirely in index-tracking funds while using a high-alpha manager for emerging markets, so they might choose to keep 60% of their hedge-fund allocation in the index while allocating 40% to hand-picked, high-alpha managers. The passive revolution is likely to be just as transformative in the hedge-fund universe as it has been elsewhere. Investable hedge-fund indices offer investors huge benefits through greater convenience and reduced costs. And, given the attractions of hedge-fund beta, those who take advantage of these new SAMURAI indices can hope to give their portfolios a real cutting edge.