Performance envy and due dilligence

07Sep06

It seems that in a world of increasing investment options it is getting ever harder to defend what is perceived to be lagging performance. Paul Kedrosky highlights the news that the head of one of the country’s largest university endowments is leaving for the private sector. Given the high-profile pressures on these individuals Kedrosky is not all that surprised by this trend.

A recent story in the Wall Street Journal by Alistair Macdonald on the rough going so-called “investable” hedge fund indices have seen of late. While many have believed these vehicles were a veritable oxymoron, others have seen investable hedge fund indices as an easy entry point into the world of hedge funds.

The only problem is that it was never that simple. The strict requirements of investable hedge funds has created a situation where they did not truly reflect the performance of the broader world of hedge fund returns.

The result is that many investable index funds don’t reflect some of the industry’s highest fliers. “Because of the requirements investable indexes have, in terms of needing funds to be open to new cash, they tend to get the second-tier funds, as the best funds are closed to new cash,” said Francois-Serge Lhabitant, head of research at alternative investment group Kedge Capital in London.

In addition to this negative selection effect the article highlights the role additional management fees play in dragging down returns to the vehicles that are meant to track the performance of investable hedge fund indices. This is also a problem faced by fund of hedge fund managers.

One possible solution we noted earlier was the potential to use commonly traded instruments to create so-called synthetic hedge fund returns. Synthetic hedge funds are by no means a panacea, but they do have some distinct advantages. Since they are created with liquid, market-traded vehicles they are by their nature transparent. In addition the issue of fees on top of fees also falls away. On the downside they are at best an approximation of the true hedge fund universe and have significant “model risk.” That said for those seeking an easier entry into the world of hedge funds this avenue does hold promise.

This is of course one investment option for endowment managers. Given the competition, there will always be boards with “investment envy.” The challenge for all investors is to venture into new investment areas (and vehicles) when they are fully comfortable with the risk/reward profile, and no sooner. Looking over your shoulder at the performance of your competition should not short circuit this due diligence process.

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