Hedge funds have historically been important asset allocation components of well-diversified portfolios for sophisticated investors. The endowment model pioneered by David Swensen1 to manage the Yale Endowment Fund argues for alternative investments in general and hedge funds in particular to play more significant roles in portfolios. The limited-constraint nature of hedge funds is intuitively appealing to investors, as studies have shown that constraints limit the alpha potential of portfolios. Perhaps the most widespread example of the limitation on regulated investment products is the limitation on short positions. Traditional long-only managers can only invest in long positions up to 100 percent of the value of their portfolios, by definition. By relaxing the long-only constraint, researchers have shown an increase in the potential to add alpha and minimize risks.2 This research has led to the widespread adoption of long/short portfolios (also called active-extension strategies or 130/30 portfolios representing long weights of 130 percent and short weights of -30 percent).
Despite the benefits of hedge funds, a number of characteristics have limited their desirability and accessibility from the perspective of the average investor. As virtually all hedge funds are organized as limited partnerships (LPs), there are limits on the number and types of investors a fund can have. These limits relate to minimum investor asset levels and minimum income requirements, among other things. These restrictions effectively eliminate access to hedge funds for most individual investors. For those investors that do meet the accredited investor minimums, obstacles may still remain. Among these are:
- Manager selection − Performing the necessary due diligence to find a good hedge fund can be very time-consuming and requires a certain level of investment acumen. Further, once an investor identifies a good fund, it is possible that the manager may not be accepting new clients or that the hedge fund selected may not perform as desired.
- Liquidity − Hedge fund industry standards are to provide liquidity on a monthly or quarterly basis with advance notice of up to 45 days or more. Some investors want additional liquidity.
- Transparency − Reporting requirements in the hedge fund industry are far more relaxed than for registered investment products. In an attempt to protect their intellectual capital, many hedge funds do not provide regular updates on positions held in their portfolios.
- Fees − Hedge funds typically charge management fees of 1-2 percent of assets plus performance fees of 10-20 percent of the profits of the portfolio. To avoid some of the manager selection issues noted above, some investors choose to invest in hedge funds via a fund-of-funds structure. The fund-of-funds will add a fee for their service that may be an additional 1 percent of assets plus a percentage of the profits.
Academic researchers began to study the positive performance characteristics of hedge funds in the 1990s and 2000s. Several influential papers established that up to 77 percent of hedge fund returns can be attributed to beta, i.e., exposure to broad asset classes or factors, with the remaining 23 percent being alpha, i.e., performance specific to the strategies of the fund. Further, studies have shown that by using variants of Sharpe’s returns-based style analysis, it is possible to estimate the beta exposures of hedge funds. Subsequently, researchers showed that by using liquid, exchange-traded instruments, it is possible to create a return series that approximates the beta returns of hedge funds. Investment professionals began to use the building academic body of research to develop indexes designed to mimic the performance of hedge fund beta. Starting in the mid-2000s, Merrill Lynch introduced the Merrill Lynch Factor Index, followed by Goldman Sachs, who developed the Goldman Sachs Absolute Return Tracker (GSART) Index. Both of these indexes are designed to track broad hedge fund indexes. IndexIQ followed these launches with the first suite of hedge fund replication indexes designed to replicate individual hedge fund strategies rather than broad indexes. More recently, Credit Suisse has also introduced indexes tracking individual hedge fund strategies.