It was the second such hedge fund index to be launched by a Wall Street firm in 2006. Merrill Lynch launched the ML Factor Index in April for institutional investors. This emulates the behaviour of well-known hedge fund industry benchmarks using a dynamic portfolio that includes the S&P500, the Russell 2000, Morgan Stanley’s EAFE and Emerging Markets free indices, the US Dollar index and one-month Libor.
“We have a rules-based algorithm that tracks the behaviour of these benchmarks, which basically represents hedge fund beta,” says Steve Houston, a managing director in Merrill Lynch’s global markets division, and head of structured products in the Americas. The Merrill Lynch Factor Index has a 95% correlation to well-known, non-investable hedge fund index industry benchmarks.
Looking at the performance of the index in line with other hedge fund indices, one might question how much alpha hedge funds are actually producing. The ML Factor Index, which offers daily liquidity, low fees and complete transparency, produced returns in 2006 almost in line with the HFRI Fund Weighted composite index, which is the average return of the 1,700 or so hedge funds that report to it. The ML Factor Index, for example, was up 11.2% in 2006 to mid-December, while HFRI’s composite hedge fund index was up 11.9% by the end of November.
Investors use hedge funds largely because they believe that managers are producing alpha and for this they are prepared to accept high industry-standard fees, less liquidity and a lack of transparency. So are these indices a threat to hedge funds’ business?
Liquid beta
Although it is not in the obvious interests of Wall Street banks to agree with the view that the indices are a practicable alternative to hedge funds – given that hedge funds are clients, and that the banks run hedge funds of their own – Merrill’s Steve Umlauf, a managing director in the global markets division, makes a fair point. “We definitely think alpha exists, and if you can identify it, then it is worth accessing and paying a premium to do so. However, we do think beta is becoming more obvious in the hedge fund space, as it has in the mutual fund space, and that beta should be sold in a liquid, low-cost and transparent format.”
Interestingly, Houston and Umlauf say the response from hedge funds and funds of hedge funds to the Merrill index has been positive. “We’re actively talking to both parties with regards to using the index as a cash management tool,” they say. Umlauf says that Merrill Lynch has also launched “a series of sub-strategy indices, encompassing convertible arbitrage, volatility arbitrage, long/short equity and merger arbitrage, which can be used by single-strategy funds to invest in while looking for opportunities.”
Houston says: “For funds of hedge funds, which spend a lot of time in transition management, it’s not that infrequent to hold cash. The sub-strategy indices offer alternatives.” Merrill Lynch has discussed the possibility of shorting its indices to eliminate beta exposure and isolate pure alpha. “These indices could provide a whole new means of alternatives investing and could complement further growth in the asset class,” says Houston.
