Index fund and hedge fund managers believe that an investment strategy combining their products, and excluding traditional active fund managers, is optimal – but their consensus comes from radically different points of view.

For index fund managers, hedge funds and other alternative investments (such as direct equity funds or small-cap funds) can bolster a pension fund’s returns. Vincent Duhamel, CEO at State Street Global Advisors Asia, notes these alternative strategies also complement one of the key pillars of index investing: diversification. He also acknowledges that for some asset classes, such as small-cap stocks, indexing is an inferior strategy.

For hedge fund managers, indexation offers two advantages. First, they say the combination of indexing and hedge funds can deliver the same exposure as a traditional active fund manager, but at less cost and lower risk. But for Andrew Alexander, director at The Pacific Group in Hong Kong, “Indexing is a self-defeating philosophy.” He notes if too much money is dedicated to indexation, the markets become inefficient and active managers can outperform.

Shadow play

Alexander says academics have identified this occurs when indexers comprise over 30% of the market. Although indexers aren’t this big, particularly in Asia, the trend of indexing is so strong that most active managers follow popular indices such as the MSCI all-Asia free ex-Japan. These so-called “shadow indexers” are more focused on keeping clients by not underperforming a benchmark, rather than making money.

Hedge funds, on the other hand, just care about making money, particularly when their partners are also major investors. This not only allows them to take advantage of market anomalies, but means they are not correlated to indices. Alexander uses the recent dropping of Cheung Kong from the MSCI index as a good example of how shadow indexers caused a huge price discrepancy that allowed Pacific to rack up profits by shorting Hutchison Whampoa and buying Cheung Kong. “It was a classic pair trade – all because of shadow indexing.”

Brian Haskin, regional director for North Asia at Barclays Global Investors, warns that pension clients mustn’t be hasty when adding active managers to a core index portfolio. Investors must first determine their risk tolerance relative to the active return they expect, and then select managers on that basis. “Don’t just hire managers just because they are active or just because they have higher active risk,” he says.

One problem, however, is that pension consultants may be familiar with traditional active fund managers, but avoid hedge funds. “Consultants hate us,” says Alexander. He notes in the United States, there is a new and growing industry of hedge fund consultants, but these have yet to make their way across the Pacific.