Equally weighted indices are widely used in the world of hedge funds because their calculation is remarkably straightforward and requires limited datasets. One just has to sum the performance of the N hedge fund managers that constitute the index and divide the result by N to obtain the index performance.
There is no need to track the assets of each individual hedge fund month after month (as required in an asset-weighted index) and no need for using more complex averages. This explains why the majority of hedge fund indices are equally weighted.
Equally weighted indices provide a clear indication of the average percentage performance of their constituent funds. However, their apparent simplicity also comes with several shortcomings:
- Emphasis on smaller funds. Equally weighted indices consider the performance of small and large hedge funds the same way—each of them receives an identical weight in the index. By contrast, in an asset-weighted index, larger hedge funds would receive a larger weight. Supporters of equally weighted indices often argue that this is an advantage because the resulting index is less concentrated and avoids being driven by the largest funds. However, reality is often that investors feel more comfortable and are willing to invest in larger established funds.
- Constant rebalancing. The returns of an equally weighted hedge fund index are not representative of the returns of a buy and hold strategy. Indeed, as soon as the value of one index component changes, the index is no longer equally weighted and requires some rebalancing. Theoretically, one would need to constantly rebalance the index to maintain an equal-weighted approach. While this is easy to do in theory, it is often harder to implement in practice as the underlying hedge funds may not authorize in and out movements on a monthly basis. Thus, the challenge facing any index provider is determining the adequate rebalance frequency.
- Contrarian strategy. Rebalancing an equally weighted index is often counterintuitive in terms of investment strategy because one needs to sell winners (funds that performed well) to buy back losers (funds that underperformed). In practice, investors tend to allocate more to funds with a better performance.
|Equally Weighted Index (HFRX)|