Responding to the growing popularity of hedge funds, investors have gravitated to index funds that purport to mimic the returns of a broad basket of hedge funds, similar to mutual funds that track the Standard & Poor’s 500 index.
In theory, “investable” hedge fund indexes, first launched in 2002, have merit. They provide diversification, risk management, greater transparency and the ability to shift money in or out on a weekly basis, vs. the one- or two-year lockups required by hedge funds, says Scott Berniker of MSCI Barra, which constructs hedge fund indexes.
But, in reality, returns posted by investable hedge fund indexes have been underwhelming because of the way they are constructed. Not only have these funds lagged behind the U.S. stock market, they often post smaller gains than the indexes they track. In 2006, the MSCI Hedge Invest index gained 7.3%, a full 4 percentage points less than the 11.3% return of the MSCI Hedge Fund Composite index, which it is designed to mirror. A big reason for the muted returns is it is hard to build an index that truly mimics the hedge fund universe. Obstacles include:
