Hedge funds are still far from entering the mainstream, but they will gain access to a broader distribution thanks to a new index from Standard & Poor's of New York.

Smaller than standard benchmarks, the S&P Hedge Fund Index creates an investment tool that opens hedge fund investing to less wealthy clients than required by hedge funds themselves and that, for the first time, will offer daily valuation accessible to the general public.

The index tracks a universe of 40 hedge funds further broken down into three sub-groups: arbitrage, event-driven and directional/tactical. All constituents must agree to provide S&P with daily valuation and "high-quality reporting," according to a company brochure.

Other hedge fund indexes, such as the CSFB/Tremont Hedge Fund Index, already exist. But the S&P, rather than creating a broad benchmark that tracks as much of the 6,000-member hedge fund universe as possible, has created this index specifically as a marketing tool for investment professionals.

As with any of its indexes, S&P has also licensed the index for product use exclusively to PlusFunds of New York. That fund company, in turn, has secured distribution for its incipient products.

Is Less More?

This focus on distribution creates a potentially misleading situation for investors, said Mendel Melzer, CIO at Newport Group, an investment advisory firm in Heathrow, Fla.

"The problem is that by choosing only 40 strategies, there's a real potential for the index not to be reflective of the average hedge fund that someone might get into," Melzer said.

Melzer does see some benefits to this new, specialized hedge-fund index, however. Because hedge funds are not required to report, even those that do so may later elect to stop if performance starts going south; the S&P index includes only funds with high integrity in reporting, so "they're not including any three-man shops," Melzer said.

Furthermore, S&P's index includes only hedge funds that are accepting investments, a further limitation that has nothing to do with ultimate performance. This requirement just means that index-based products will actually be able to buy into those funds. "What I worry about with this index is, it is neither a passive market representation of hedge fund strategies, nor is it explicitly designed [for] high-performing hedge fund of funds," Melzer concluded.

Product designs include domestic partnerships and SEC-registered 40 Act funds, which are more available than hedge funds but less so than mutual funds. For instance, such vehicles may have an unlimited number of investors but require accreditation of $1 million in total net worth, including residences, said Christopher Sugrue, chairman of PlusFunds.

DB Absolute Return Strategies of New York, Deutsche Bank's global hedge fund business, has an exclusive agreement to distribute the PlusFunds S&P Hedge Fund Index products to institutional clients. The indexed products will actually broaden the company's reach by attracting institutional investors who otherwise would avoid the risk involved with picking individual hedge funds.

"We believe that a transparent, rules-based, passively managed index product for the hedge fund universe will help to lower the barrier to hedge fund investing for many institutional clients," said Josh Weinreich, global director of DB Absolute Return Strategies.

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