Indices Representing Alternative Investments

As alternative investments have increased in popularity, it has become necessary to create alternative investment indices. The most widely followed classes of indices include commodities, real estate, and hedge funds.

Commodity Indices

These indices consist of futures contracts on one or more commodities. Although some commodity indices may include the same commodities, returns may differ based on the weighting method. Since there is no clear way to weigh indices of futures contracts, commodity index providers create their own methods. For instance, some indices contain a fixed number of equally-weighted commodities, a combination of liquidity measures and world production values, or have a committee to determine index weights.

Due to significant variance in weighting methods between indices targeting the same markets, commodity index portfolios may exhibit very different risk and return profiles. Also, price changes within a commodities index will differ significantly from the prices of underlying assets.

Real Estate Indices

Real estate indices include the highly illiquid market for real estate and the highly liquid market for real estate securities. Real estate indices are categorized as appraisal, repeat sales, or real estate investment trust (REIT) indices.

Hedge Fund Indices

These indices track hedge funds – private investment vehicles that use leverage, long-short strategies, and charge additional performance-based fees. Since hedge funds are only required to report performance to their investors, their inclusion in these indices is usually voluntary. As a result, hedge fund indices typically struggle with performance differences between similar indices (due to hedge funds reporting to one index, but not the other) and survivorship bias (exclusion of poorly performing and/or closed funds).

Question

The performance of which of the following can be easily duplicated by an index fund?

1. REITs.
2. Real estates.
3. Hedge funds.

Solution

The correct answer is A.

REITs are highly liquid securities and there are a number of REIT indices in existence that accurately track the performance of REITs.

A is incorrect. A real estate index would be very difficult, if not impossible, to replicate due to the illiquid and heterogeneous nature of real estate investments.

B is incorrect. Hedge fund indices would be similarly difficult to replicate due to their illiquidity, limited access, and the inherent biases of hedge fund indices.