You Are What You Measure
“You are what you measure” is a favorite saying of management gurus, and there’s some truth to it. For investors, a corollary might be “choose your benchmarks carefully” when measuring returns.
Hedge funds are a case in point. Broad-based hedge fund returns have been compared to those of the S&P 500 Index or the MSCI World Index and, in that context, have underperformed in some periods. But, the most widely cited hedge fund index, the HFRI, incorporates the returns from investment strategies that include everything from long only and convertible arbitrage to commodities and distressed debt. Its composition is materially different from the long-only equity indexes against which it’s often measured.
In a way, this mis-measurement is an artifact of how many investors historically viewed the role of hedge funds. These funds were generally thought to be absolute return vehicles, overseen by brilliant, if sometimes eccentric, managers, designed to blow away the benchmarks. But for many, this was never really the point. Hedge funds are “hedged” – generally seeking to provide downside protection as well as upside returns.
The introduction of low-cost, liquid alternative ETFs designed to replicate hedge fund strategies shifted the landscape. This made hedging strategies more widely available, and introduced a whole new group of investors to the asset class. But in many cases, the role of these funds in a portfolio is still unclear.
For most investors, the appropriate benchmark is the one best suited to their long-term investment goals and tolerance for risk. Based on that, liquid alternatives will play a different role for different investors. In some cases, they may, in fact, serve as an absolute return strategy. In others, they will provide a more conservative way to access the markets.
Depending on strategy, the return expectations – and the benchmark – will vary. In some cases, the S&P 500 Index or the MSCI World Index may be appropriate; in others, the target may be 3-5% above the risk-free rate of return, with lower volatility and downside protection.
A second important consideration when thinking about benchmarks is the measurement period. Stocks have been good to investors over the last several years, delivering one of the longest-running bull markets in history. But, markets have historically been cyclical, and the day will come when investors will again value downside protection – a hedge. A reasonable analysis of fund performance should capture a full cycle to really provide a good idea of how a fund performed.
All investments are subject to risk and will fluctuate in value. Alternative investments are speculative, entail substantial risk, and are not suitable for all clients. Alternative investments are intended for experienced and sophisticated investors who are willing to bear the high economic risks of the investment. Investments in absolute return strategies are not intended to outperform stocks and bonds during strong market rallies. Hedge funds and hedge fund of funds can be highly volatile, carry substantial fees, and involve complex tax structures. Investments in these types of funds involve a high degree of risk, including loss of entire capital. Treasurys are backed by the full faith and credit of the Federal government as to the time payment of principal and interest.
HFRI Index incorporates the returns from investments strategies that include everything from long only and convertible arbitrage to commodities and distressed debt.
MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. As of June 2007 the MSCI World Index consisted of the following 23 developed market country indices: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom, and the United States.
S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stock-market performance.
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
Risk-free rate of return is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the interest an investor would expect from an absolutely risk-free investment over a specified period of time.
The information and opinions contained herein are for general information use only. IndexIQ does not guarantee their accuracy or completeness, nor does IndexIQ assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are as of the date of this report, are subject to change without notice. Past performance is no guarantee of future results.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services. IndexIQ® is an indirect wholly owned subsidiary of New York Life Investment Management Holdings LLC. ALPS Distributors, Inc. (ALPS) is the principal underwriter of the ETFs. NYLIFE Distributors LLC is a distributor of the ETFs and the principal underwriter of the mutual fund. NYLIFE Distributors LLC is located at 30 Hudson Street Jersey City, New Jersey 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is Member FINRA/SIPC.