Vol.30 - Hedge Fund Strategies Explained III

Hedge Fund Strategies Explained: Part III
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By Sridhar Venki & Simon Hookway, MSS Capital Ltd. | October 13, 2005

Investing in Hedge Funds via an Index Product -
The FTSE Hedge Index / FTSEhx Fund
The FTSE Hedge Index series is the latest addition to FTSE Group's portfolio of global benchmark indices. The index series aims to provide a daily measure of the aggregate risk and return characteristics of the broad-based universe of investible hedge funds in a representative, diversified, transparent and evolutionary manner. The index is weighted using FTSE’s “Investibility” methodology. Investibility is best viewed as a natural extension of the free-float methodology that FTSE uses for its equity indices.

Index Methodology
Initially, a hedge fund universe of over 6,000 funds was established using a variety of different data sources and industry contacts. The first FTSE Ground Rule was then applied to this universe, namely the requirement of a minimum track record of two years. Those hedge funds complying with this requirement were then grouped into the eight major trading strategies and each hedge fund was quantitatively assessed for representativeness relative to its strategy group as a whole, with the least representative removed from the universe. Any hedge funds following a strategy not consistent with the standard eight strategies within the Index were also removed from the universe.

Further FTSE Ground Rules were then applied to establish basic eligibility, namely a minimum fund size of US$50 million, quarterly liquidity or better, with the hedge funds having to be open and accepting new money. There are no closed hedge funds within the Index. The Investibility concept was then introduced at the constituent selection stage of the Ground Rules to firstly determine the strategy weightings within the Index and secondly to assign a weighting to each hedge fund within its strategy.

The investibility weighting is a function of a fund’s current size and the remaining capacity available until it reaches an asset size at which it ceases to accept new money.

Each hedge fund was then ranked within its strategy in accordance with its investibility weighting and the final constituent managers were selected on the basis of their representativeness, investibility and willingness to comply with all of the platform requirements, especially transparency.

Weightings
The FTSE indices were launched in July 2004 with 40 constituent hedge funds, although the number of funds is expected to grow over time, in order to keep the diversification benefits.

As a result of the implementation of the Ground Rules to create the FTSE Index, the constituent hedge fund managers have the following geographical location: 68% USA, 29% Europe and 3% Asia. The eight strategies represented within the Index are Equity Hedge 30%, Fixed Income Relative Value 13%, CTA/Managed Futures 13%, Distressed & Opportunity 10%, Merger Arbitrage 10%, Global Marco 8%, Convertible Arbitrage 8% and Equity Arbitrage 8%.

Due Diligence
All hedge funds selected for the Index in accordance with the Ground Rules must additionally pass a rigorous due diligence process covering quantitative, qualitative and operational areas (ensuring the hedge fund in question is of institutional quality and has sufficient internal and external controls) prior to their inclusion within the Index. The due diligence consultant for the platform is Harcourt Consulting AG, headquartered in Zurich.

In addition, the Index is overseen by the FTSE Hedge Fund Advisory Group, which comprises independent and authoritative individuals who are senior professionals in investment management. No hedge fund will be included in the Index until it has received final approval from the committee. Other platform parties include FTSE Group (index licensor), Derivative Portfolio Management LLC (administrator) and MSS Capital Ltd (investment adviser). .

Investment Opportunity
Global financial institutions, family offices and high net worth individuals are increasing their allocations to alternative investments. Relative to the difficulty of selecting an actively managed fund of funds or the even greater difficulties of selecting individual hedge funds within the various strategies from such a large universe, the FTSE Index offers a diversified, transparent and low cost means of obtaining exposure to the global hedge fund sector.

Investors can gain an exposure to the hedge fund sector by investing in The FTSEhx Fund, a fund of hedge funds incorporated in the Cayman Islands and whose shares are listed on the Irish Stock Exchange. The Fund invests in the constituent hedge fund managers of the FTSE Hedge Index series in the proportion to which these managers are investibility-weighted within the Index.

The allocation to each constituent fund is generally via a managed account. The managed account gives the required levels of transparency and control, and is governed, together with liquidity and capacity terms, by means of legally binding documentation between the parties. The transparency of the investments made in the constituent hedge funds by the Fund allows MSS Capital to actively manage the risks associated with hedge fund investing. The MSS Capital risk management system allows day-to-day monitoring of various aspects of each of the constituent hedge fund assets, set against certain parameters, for example, the total level of gearing being used, concentration of risk and types of traded instruments being used. The risk management system is also used for monitoring style drift within each constituent hedge fund. Any breach of the agreed investment parameters of the managed account may lead to the manager being removed from the FTSE Index and thus as an investment from the portfolio of the Fund.

There are 12 different ways to invest in The FTSEhx Fund. Investors can allocate capital to the Global share class, which gives exposure to all 40 constituent hedge funds across all styles and strategies. Alternatively, they can allocate to any of the three style classes (Directional, Non-Directional and Event Driven) and gain exposure to just the constituent hedge funds in that style. Or investment can be made into any of the eight Strategy classes to gain exposure to just the constituent hedge funds in that strategy. Investors can therefore tailor their investment according to their exact requirements.

The Fund offers monthly liquidity. The initial minimum subscription amount for each new investor is US$500,000 (or equivalent), with a minimum of US$100,000 (or equivalent) in any one share class. Additional subscriptions for an established investor are subject to a minimum of US$100,000 (or equivalent). There are no subscription charges levied by The FTSEhx Fund. Shareholders may redeem up to 100% of shares held on any dealing day with 35 calendar days written notice and may redeem up to 10% of the shares held (within each individual share class) on any dealing day with 5 business days written notice prior to calendar month end. There are no redemption charges levied by the Fund.

Performance
The performance of hedge funds compares favourably with traditional asset classes such as equities and bonds. Since December 1997, global equities have returned an annualized 3.8% (FTSE All-World Index), global bonds an annualized 6.7% (JPM Global Bond Index) and hedge funds* an annualized 8.4% (FTSE Hedge Global Composite Index). More impressively, hedge funds achieved this superior performance with just 3.8% annualized volatility, which is significantly less volatility than equities (15.6%) and bonds (7%).

Sridhar Venki -- Investment Manager, MSS Capital Ltd
Simon Hookway -- Chief Investment Officer, MSS Capital Ltd
* FTSE Hedge Index Series, net of fees, 31st Dec 1997 to 31st August 2005 (pro-forma figures prior to April 2004)

MSS Capital Ltd
Sridhar Venki - Investment Manager
Simon Hookway - Chief Investment Officer

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