There are a number of benchmarks available for hedge funds, distinguished primarily by the frequency of data reporting (monthly or daily), whether they are investable or not, and whether they list the actual funds from which they are comprised.
Principle differences among the indices include:
- Selection criteria – what kind of track record or level of assets must a fund attain in order to qualify for inclusion?
- Style classification
- Weighting scheme – usually either equal weights or based on assets under management
- How frequently the weights of the constituent funds are rebalanced
Since hedge funds often promote themselves as absolute return vehicles (and thus do not have a direct benchmark) that absolute return nonetheless must be measured in terms of some benchmark. Important questions to consider are whether any alpha reported is sensitive to the benchmark in use and whether the alpha takes into account the true systematic risks faced by the portfolio.
There are also a number of limitations to most of the available hedge fund indices, including:
- Results are self-reported by the managers and may not be completely neutral or accurate
- Databases reflect survivorship bias as poorly performing managers exit leaving only the best included. This results in an upward bias to reported returns.
- The frequency of data reporting may lead to stale prices and distort correlation measures.
- Missing data can be filled at the manager’s convenience, leading to a backfill bias.
Studies to determine whether hedge fund returns can be mimicked using passive strategies have shown mixed results but do show that returns are influenced largely by the trading strategy employed. Market neutral strategies may offer better diversification to traditional asset classes.
Hedge fund returns have been shown to exhibit low skewness and high kurtosis, which are undesirable features. Mean-variance optimizations are sensitive to errors in the return estimates, and historical data (as discussed above) can be unreliable.For more information, see all articles on: Active Management, Alternative Assets, Asset Allocation, Hedge Funds, Investment Returns, Portfolio Management, Risk Management See also: