Alternative investments indices
While equity and fixed income securities garner a large share of the global investments, investors look to diversify their risks and earn potential high returns in other asset classes like real estate, commodities, hedge funds etc.
Commodity indices represent future contracts on one or more commodities. The key challenges in building a commodity index are: a) assigning weights to different commodities as they don’t have market capitalization like equities. So, their weighting can be equal weighted (CRB Index), on the basis of production value or liquidity. S&P GSCI index uses a combination of liquidity and production value and b) actual versus futures return as indices are based on future value of contract which reflects risk-free return, roll yield, and the changes in futures prices. Therefore, the return of a commodity index can be quite different from the return based on the changes in the prices of the underlying commodities.
Real estate indices represent returns based on an appraisal of properties, repeat property sales, and that of REITs (Real Estate Investment Trusts). REITs are more liquid than the underlying property. REIT indices are based on publicly traded REITs with continuous market pricing and thus, their value is calculated continuously.
Hedge funds pool money from generally high net worth individuals and invest in non-traditional investments or instruments. They often deploy leverage to enhance returns and take both long and short positions as well. Hedge fund indices generally give equal weights to the constituent funds. An issue with hedge funds is that they are not very tightly regulated and it is up to them to declare their performance or not.
The performance data of the hedge funds is compiled on the voluntary cooperation of hedge funds. Hedge funds are not required to report their performance to any party other than their investors. Therefore, each hedge fund decides to which databases it will report its performance. So, the constituents of hedge fund index determine the index rather than the index providers determining the constituents.
The voluntary reporting also leads to issues like survivorship bias and backfill bias (leading to upward biased performance). It also leads to different hedge fund indices reporting different performance over the same period of time across the globe.
Check your concepts:
(46.13) Which of the following is least likely a component of the returns of the commodity indices?
(a) Risk-free interest rate
(b) Roll yield
(c) The changes in spot prices of constituent commodities
(46.14) Real estate indices are least likely to be characterized as:
(a) Repeat sales indices
(b) Appraisal indices
(c) Market capitalization indices
(46.15) Which of the following statements is least accurate about the hedge fund indices?
(a) There is little overlap of funds covered by different indices
(b) The performance of the hedge fund indices is upward biased
(c) The index providers determine the constituents of the hedge fund indices
Solutions:
(46.13) Correct Answer is C: The components of the return of commodity indices are the risk-free interest rate, roll yield, and the changes in the futures prices of the constituent commodities.
(46.14) Correct Answer is C: Real estate indices are characterized as appraisal indices, repeat sales indices, and REIT indices.
(46.15) Correct Answer is C: The constituents of the index determines the index rather than the index providers in case of hedge funds.
Exam Alert: It is an important area and candidates must focus on the finer points in the construction of indices representing alternative investments. You are likely to be asked one question from this area in the exam.
