S&P Enters the Field

In October of 2002, Standard & Poor's joined the fray by launching a group of hedge fund indexes, led by the S&P Hedge Fund Index (HFI). You can view the performance of all S&P hedge fund indexes, updated daily, at:

• http://www.standardandpoors.com

Click on "Indices" and then "Browse by Index" and then "S&P Hedge Fund Indices."

Of course, the S&P name alone can add momentum to any indexed investing concept. But in creating the HFI, S&P also applied brilliant structural thinking. Specifically, it created an equally-weighted index allocated among three separate strategies, with three "style baskets" per strategy (nine total), and 30-40 individual hedge fund managers, all of which have passed due diligence screening and are currently accepting investments. You can read specifications in S&P's white paper here:

• http://www.hfinvest.com/Files/White%20Paper%20Jan%2003.pdf

The S&P structure created perhaps the most diversified of all hedge fund indexes, with the lowest volatility and correlation to the S&P 500 Index. When the HFI was launched in October of 2002, S&P said that on a pro forma back-test basis the HFI had a standard deviation of 3.2, compared to 18.6 for the S&P 500 Index and 3.3 for the Lehman Aggregate Bond Index. Its correlation was 0.30 with the S&P 500 and -0.05 with the Lehman Aggregate Bond Index. The index's actual performance from 10/02 through 4/04 has closely matched pro forma results, as shown in the table below.

Sources: S&P for backtest; PlusFunds for actual.

In short, the index that S&P created was designed to be (and thus far has been) capable of producing a return of about 9% per year, with volatility like watching paint dry. If you could invest up to 20% of client assets directly in this index, with the same economy, transparency, accessibility and tax-efficiency offered by an S&P 500 Index fund, it might indeed be an attractive proposition. That choice is not yet possible, but it's on the way.

The Emergence of Alternative Index Fund Investing

S&P has awarded an exclusive perpetual license to develop hedge fund index products to PlusFunds Group, a New York City-based company jointly owned by several large financial institutions. PlusFunds has created its own family of indexed hedge fund products under the SPhinX brand and captured $2.5 billion in assets. The first SPhinX products indexed the HFI and its three component strategies (Event-Driven, Directional/Tactical, Arbitrage), along with the S&P Managed Futures Index and the S&P Long/Short Index. The main markets for these products to date have been institutional and offshore.

In addition to acting as a passive fund-of-funds manager, PlusFunds also serves as the licensor of S&P hedge fund indexes to other entities. To date, the best attempt to make indexed hedge fund investing accessible and transparent has been made by Rydex, a mutual fund group that has carved out a niche in alternatives.

Rydex SPhinX

The Rydex SPhinX Fund, which has raised more than $120 million since launching on June 30, 2003, is structured as a registered closed-end investment company. It is available to Rule 501(a) "accredited investors" with a net worth in excess of $1 million (single or joint) or income in excess of $200,000 single ($300,000 joint). The minimum investment is just $25,000 to participate in all 36 component hedge fund managers of the S&P HFI on an equally-weighted basis per basket. (There are nine baskets.)

In addition, Rydex SPhinX allocates about 10% of its assets to the SPhinX Managed Futures Fund, and this further reduces correlation and volatility-;because managed futures correlate negatively with the S&P 500 Index and have modestly positive correlation with the HFI. The addition of managed futures to the index fund makes the paint dry even slower. In its first nine, Rydex SPhinX produced a return of 4.8% with a standard deviation of 1.6%, about half the volatility of the Lehman Aggregate Bond Index.

Three important points of the Rydex SPhinX structure are noteworthy in addressing the five issues mentioned at the top of this article:

1. All 36 hedge fund managers have agreed to hold the fund's assets in separate accounts, not the commingled partnerships generally available to individuals. This gives Rydex transparency in seeing the positions and trading patterns of each manager, a major protection for reducing business risk. Rydex didn't obtain this benefit by virtue of awarding these managers large assets, either. For example, as of March 31, Rydex had allocated about $2.6 million to each of five equity market neutral managers. An individual investor probably couldn't command a separate account with these managers for less than $20 million-;but Rydex obtained this benefit by virtue of its fund-raising potential, combined with the desire of these managers to attract more assets to the HFI index investing concept. They clearly see it as a conduit to tap the fund-raising power of financial professionals.
2. Since Rydex SPhinX is an investment company that owns an interest in each manager's portfolio, it isn't required to pass through to investors all the trading gains or losses produced by sub-advisor managers, as a partnership must. Any gains or losses not distributed to Rydex are considered "unrealized" and build up inside the fund. So, the tax consequence is similar to that of a very low turnover index fund, like the S&P 500. On a $100 initial NAV, Rydex SPhinX distributed in its first six months an income dividend of 56 cents and a long-term capital gain distribution of 5.2 cents.
3. To provide compensation to financial professionals, Rydex SPhinX is structured as a load fund with a maximum sales charge of 3%. The sales charge can be waived for clients of Registered Investment Advisors who wish to wrap the product inside their own fee-based programs.

Rydex SPhinX has addressed five of the six major concerns that advisors may have about alternatives-;all except cost. Currently, Rydex Global Advisors has capped its advisory and administrative fees at 1.95% through a fee waiver. (Without this waiver, expenses would have been 3.36%.) But this is in addition to the hefty fees extracted by each hedge fund manager. The 9% pro forma and actual return produced by the HFI, calculated after manager-level fees, would shrink to about 7% with the Rydex fee waiver and to less than 6% without the waiver. At that point, the investment starts to look like a 10-year Treasury bond not only in terms of volatility but also return.

However, the cost of indexed hedge fund index products could decline in several ways. First, underlying managers may see that reducing their fees would attract more assets to the concept. Secondly, it may be possible to track fairly closely to the HFI with a combination of hedge fund investments and lower-cost derivatives. (Rydex has the right to use derivatives in its fund.) Thirdly, licensees pay a cost to work through PlusFunds and use the S&P HFI name, and that cost is 0.20% of assets for Rydex SPhinX. But it is possible to study the track S&P has created and develop clones of it, without necessarily licensing the S&P imprimatur.

In any case, interesting new ideas are on the way. For example, one innovative firm in the alternative space, REFCO, is offering guaranteed notes that participate in the upside potential of a combination of a managed futures fund and PlusFunds' SPhinX fund. This is like watching paint dry very slowly, with the added assurance that 100% of principal is protected!

Before you allocate a portion of your clients' assets to alternative investments, please read the box below. Then, make sure that the five important concerns are addressed to your satisfaction. Also, recognize than even better indexed approaches are on the way that will expand the advantages of alternative investments to more clients, in ways that are less risky and more rewarding for you.

The Business Risk of Opaque Funds

A case now winding through the regulatory system and courts demonstrates how much business risk individual hedge fund managers can create, even for the most sophisticated investors and advisors. The case involves Beacon Hill Asset Management, a New Jersey hedge fund manager that collapsed amid more than $300 million of investor losses in October of 2002 (about the same time S&P introduced the HFI).

Last month, the SEC expanded a civil fraud charge originally filed against Beacon Hill in November of 2002, naming as defendants four former top executives of the group. Also, the SEC added an allegation that Beacon Hill had artificially manipulated the valuation and reporting of its core hedge fund over a period of at least nine months prior to the collapse. Part of the alleged manipulation involved transactions that benefited large institutional clients at the expense of smaller investors, while also helping the firm's principals earn performance-linked bonuses. Over many months, the SEC indicated, there was no way for investors or advisors to independently and accurately verify the fund's actual holdings or value.

Until days before Beacon Hill collapsed, the firm enjoyed an outstanding reputation as a niche manager of hedged mortgage-backed securities, with a strong track record for managing interest rate risk and avoiding directional exposure.

Two of the most sophisticated alternative investment firms in the world-;Asset Alliance, a hedge fund holding company that owned part of Beacon Hill, and Societe Generale, which issued structured products including Beacon Hill funds-;apparently did not detect the alleged fraud until it was too late.