Back-of-the-envelope analysis shows hedge fund indexes not lining up with each other this fall

Regular readers may recall a back-of-the-envelope analysis of hedge fund index dispersion that we ran a few months ago.  We found that there was a significant range in the July returns across data from different index providers.  This dispersion was modest at the composite level, but was quite significant at the sub-strategy level.

The thumbnail chart at the left contains the two standard deviation ranges of various sub-strategy indexes (one standard deviation on either side of the mean across an average of about 8 index providers per index).  If you click on the thumbnail, you’ll see that the highly diversified funds of funds and composite indexes tend to have a minimal dispersion.  However, there was significantly less commonality between the equity market neutral, managed futures, short-bias, and event-driven indexes reported that month.

While November’s results begin to roll in, we ran the same test again on October’s returns (which have all now been fully reported by the providers we track).  With the absolute value of returns significantly larger in October, one might expect the ranges to be commensuratley larger.  As you can see by the chart below, this was largely true (note that we had to set the grid lines at 5% vs. only 1% for July):

In fact, the average standard deviation across all sub-strategy indexes was up 3.5x in October (vs. July).  The standard deviation of Convertible Arbitrage indexes went from 0.44% in July to 3.58% in October, an increase of over 8x.  Oddly, the standard deviation of Equity Market Neutral indexes was actually down in October (from 2.82% in July to 1.12% in October).  In other words, there was more “agreement” between the index providers in October than there was in July.

When you rank the sub-strategies from smallest dispersion to greatest, you can see that the order has also changed.  Notably, Event-Driven went from near the bottom to the very top of the list.  In other words, most databases reported similar results for this segment in October.  Fluke or a common “event-driven” factor in October?  Who knows?

Studies have shown than a very small proportion of the world’s hedge funds actually report to 5 or more databases.  So it comes as no surprise that index returns differ across providers.  As a result, you can’t really interpret any single index as a true representation of a sub-strategy’s performance.  Unfortunately, this problem seems to be compounded by the fact that the level of alignment between providers is very dynamic on a sub-strategy basis.

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  1. Johnni Nielsen
    December 2, 2008 at 5:55 am

    I thought the EDHEC Alternative Indexes was setup to deal exactly with this issue..

  2. Alpha Male
    December 2, 2008 at 5:28 pm

    Yes. That’s right. Way back in 2003 Edhec developed a set of indexes that were essentially an “average of averages”. At the time, they wrote: “Given that it is impossible to come up with an objective judgment on what is the best existing index, a natural idea consists of using some combination of competing indexes…”. So we’d imagine that Edhec probably experiences the same challenges dealing with dynamically-changing ranges around each sub-index mean.

  3. Rwilson
    December 3, 2008 at 3:16 am

    Nice analysis..

  4. Lee Hennessee
    January 21, 2011 at 10:31 pm

    Hennessee Hedge Fund Index
    1987- present

    Hummmmmm !

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