Merrill Lynch Releases New Hedge Fund Replication Index

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Includes: IVV, SPY
by: Richard Kang

Harry Kat, Goldman Sachs and a few other names have recently made news related to strategies designed to replicate hedge fund performance characteristics. HedgeWorld.com reports that Merrill Lynch has now joined the fray.

Of importance is this paragraph:

"Our objective is to replicate the success of [exchange-traded funds] in the mutual fund industry and to apply it to the hedge fund industry," said Heiko Ebens, head of the relatively new Americas Equity Derivatives Research group and one of the authors of the research that supported the new product. Concretely, this means the future creation of ETF products that would be linked to the new tracker, he said.

I’ve said it before and here’s further evidence that some form of ETF linked to an underlying hedge fund related instrument will one day be available. This in no way makes me a clairvoyant. After inflation indexed bonds, alternative energy, nanotechnology, private equity, infrastructure … you name it … it’s just a matter of time before the next domino falls.

But unlike what many including myself may have guessed, if this ETF is launched, it would not track a broad, commonly cited hedge fund index like those from Credit Suisse-Tremont or Hedge Fund Research. No, this one (again it’s “IF” … this is news on an index, not of an ETF yet) is quite specific referring to the Merrill Lynch Equity Volatility Arbitrage Index which attempts to replicate the returns of an S&P 500 volatility arb strategy. (Those fluent in the “greeks” can dig deeper.)

If you still have no idea what volatility arbitrage is, you know you’re not in long-only vanilla “let’s pick an ETF and plug it into our asset allocation optimizer” world anymore. Often, I try to comment on how ETFs may be used by hedge fund managers. Now we’re looking at how hedge fund strategies can be used by ETF investors.

How does a hedge fund strategy fit within a portfolio, especially one that is predominately implemented through the use of ETFs? There are many answers, but I’m not sure if going ETF all the way is the answer. I know that I’m not a fan of hedge fund indices, or some instrument whose underlying is an HFI, nor am I the biggest fan of a fund-of-funds in the vast majority of cases. Hell, I’m just not a big fan of hedge funds in general for the vast majority of retail investors period. At a certain size, the wealthy investor thinks about and implements the portfolio construction process in an “institutional” manner … whatever that is. The point is, after a certain threshold in size, fees are less onerous and detrimental to performance on a relative basis and the investor has the resources to apply the right amount (or at least better amount) of talent for the endeavor.

I’m going to watch this closely. Many investors may be enticed by the liquidity and perhaps added transparency of an ETF based hedge fund product. I wonder just how much in assets will make its way in.

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