Product and Strategy Notes: Hedge Fund Indexes Compared; New S&P 1500 ETF and Funds to Implement Model Portfolios

Hedge Fund Indexes Compared

With a growing number hedge fund index products being launched around the world, we thought it would be useful to compare the major "investable" indexes on which they are based. Launched in October, 2002, the Standard and Poor’s Hedge Fund Index (SPHINX) includes 40 equally weighted funds in the three major strategy areas: Arbitrage, Directional, and Event-Based, as well as the usual suspects when it comes to sub-categories. In July, 2003, Morgan Stanley Capital International, another indexing powerhouse, launched its own hedge fund index, based on 82 equally weighted funds. MSCI’s index covers the same ground as S&P’s but uses a very different set of terms to describe it. However, it also allows investors who use it to benchmark their hedge fund managers’ performance to access a more finely grained set of metrics that encompass not only an investment strategy, but also its use in different regions. In August, 2003, CSFB/Tremont, the producer of the equally weighted CSFB/Tremont Index, introduced its own "investable" hedge fund index. Unlike the offerings from S&P and MSCI, the CSFB/Tremont Index is asset weighted, and based on the returns generated by the 6 largest eligible hedge funds in each of the 10 sub-strategies it tracks.

Statistically, the S&P and MSCI Indexes have much more in common with each other than they do with the CSFB/Tremont Index, as can be seen in the following correlation table, which covers actual and simulated index returns between January, 2000 and December, 2003.

This impression is further reinforced by looking at the three indexes returns, standard deviations, skewness and kurtosis over this period.

These tables makes an interesting point: to a sometimes considerable degree, the benefits you perceive from investing in hedge funds may be a function of the index you use to measure them. Yet another reason, in our mind, for acting cautiously when it comes to investing in this area (for more on this, see the paper "The Brave New World of Hedge Fund Indexes" by Amenc and Martellini).

The New S&P 1500 ETF

A number of readers have emailed to ask what we think about the new Exchange Traded Fund in the United States that tracks the S&P 1500 index. There are four main indexes that attempt to track the performance of the broad U.S. equity market. Each of them now has an associated exchange traded fund. The Wilshire 5000 Index includes companies that make up 100% of the market capitalization of the U.S. equity market. In 2003, its total return was 31.6%. For more information on this index, visit www.wilshire.com. VTI is the ticker for the ETF which tracks it. This fund is sponsored by Vanguard, and has an annual expense ratio of .15%.

The Russell 3000 Index includes the top 3,000 companies in the U.S. equity market, ranked by their market capitalization. Because of this approach to constructing the index, the percentage of the U.S. market’s total capitalization that is covered tends to vary over time, but averages around 98%. In 2003, its total return was 31.1%. For more information on this index, visit www.russell.com. IWV is the ticker for the ETF which tracks this index. It is sponsored by Barclays Global Investors (the creator of iShares ETFs), and has an annual expense ratio of .20%.

The Dow Jones Total Market Index takes the opposite approach from Russell, and varies the number of companies so that it consistently covers 95% of the market capitalization of the U.S. equity market. In 2003, its total return was 30.8%. More information about this index is available at www.djindexes.com . IYY is the ticker for the ETF which tracks this index. It is sponsored by Barclays Global Investors (the creator of iShares ETFs), and has an annual expense ratio of .20%.

The Standard and Poor’s 1500 Index includes the companies covered by the S&P 500 (large capitalization), S&P 400 (middle capitalization), and S&P 600 (small capitalization) indexes. In aggregate, these 1,500 companies account for approximately 90% of the capitalization of the U.S. equity market. There is no mechanical formula for deciding on which companies are included in these indexes; rather, they are chosen by a committee at Standard and Poor’s. In 2003, its total return was 27.4%. For more information, visit www.spglobal.com . ISI is the ticker for the new ETF which tracks this index. It is sponsored by Barclays Global Investors (the creator of iShares ETFs), and has an annual expense ratio of .20%.

In general, all of these indexes do a good job of tracking the performance of the U.S. equity market. Our preference, however, is the Dow Jones Total Market Index, because its consistent market capitalization approach tends to result over time in somewhat less volatility, while still delivering returns that are comparable with those on the more inclusive indexes. Why is this the case? If you plot the number of companies in the U.S. equity market against their respective market capitalizations, you end up with quite a steep curve. In other words, relatively few companies account for the bulk of the U.S. market’s capitalization, while many of them collectively account for very little. In addition, because many of these smaller capitalization companies trade much less frequently, their bid/ask spreads tend to be wider than those on larger companies, and their prices more volatile. Hence, returns on the indexes which include a large number of these companies (i.e., the Wilshire 5000 and Russell 3000) will tend to be somewhat more volatile than returns on indexes which contain fewer of them (like the Dow Jones and S&P indexes). On the other hand, as shown by the difference between the Wilshire 5000’s 31.6% 2003 return and the S&P 1500’s 27.4%, in years in which small cap companies perform exceptionally well, there is a return price to be paid for this lower level of volatility. From our perspective, the best trade-off between these considerations is struck by the Dow Jones Total Market Index.

Funds That Can Be Used to Implement Our Model Portfolios’ Asset Allocations

This year, in our relentless quest to become ever more user friendly, we thought it would be useful to summarize in a simple table a list of index mutual and exchange traded funds that can be used to implement our model portfolios’ asset allocations. A larger list of index products, which also includes mutual funds and ETFs which can be used to take different tilts within these asset classes, is available on our website, US Index Funds and ETFs , and updated quarterly. The following table makes an important point clear: the lineup of index products that are available to U.S. dollar-based investors is still incomplete. In some cases (e.g., foreign currency bonds), we lack both index mutual and exchange traded fund products. In others (e.g., commodities), we only lack an ETF. Hopefully, those gaps will be closed later this year.

| Global Asset Class Returns | Product and Strategy Notes: Hedge Fund Indexes Compared; New S&P 1500 ETF and Funds to Implement Model Portfolios | Equity Market Valuation Update | Model Portfolio Update | Using Hedge Funds in Our Target Return Portfolios | This Month's Letter to the Editor: Frequency of Changing Asset Allocations in Index Investor's Model Portfolios |