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What? Hedge funds like hedge fund indices?

The launch of Goldman Sachs’s Absolute Return Tracker Index in Italy in December has revived the argument about the value of passive hedge fund investing through indices compared with direct hedge fund investments or investment through funds of hedge funds.

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%

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