Hedge fund replication strategies taking off locally…

Merrill Lynch has launched its ‘Synthetic Hedge Fund Replication Platform’ in Australia, the latest in an expanding range of funds management products from investment banks which are looking to provide better liquidity and lower costs among alternative strategies.

The Merrills synthetic hedge fund does not invest in hedge funds, unlike the ‘tracker funds’ provided by Credit Suisse Tremont and others, but rather in a range of asset class derivatives designed to replicate the average hedge fund performance. Visiting Australia last week, Benjamin Bowler, a managing director and co-head of global equity-linked research, said that institutional investors were increasingly wanting the returns streams available from hedge funds and funds of funds (FoFs), but investing with active managers was not always worth the fees. “Increasingly, institutional investors are recognising that this type of product represents an interesting alternative,” he said. Nicholas Allen, Merrills’ head of synthetic and alternative asset management in Australia, said that by replicating hedge fund beta, the platform provided transparency and liquidity at reduced fees and with no manager selection risk. “We think it is good for a core exposure to hedge funds,” he said. “Even FoFs are using it because you can also short your exposure.” Several hedge fund managers in the US are known to have done very well in recent months by shorting the US sub-prime market. Bowler estimates that there is about $US3 billion invested globally in these types of synthetic hedge funds. They can be delivered in a variety of ways, through a fund or a structured product provided by the bank. The Merrills platform is about 94 per cent correlated with the main HFRI index of about 1800 international hedge funds. Liquidity is a big issue for hedge funds if they go through a period of falling returns, as seen in Australia in recent weeks, when Basis Capital and Absolute Capital have put some redemptions on hold. Allen said: “If a hedge fund is blowing up, you can short the strategy and ride it through to a more orderly exit. You don’t have to physically redeem the position at what might be a very costly time. It’s a tool which can be used in much the same way as futures and ETFs (exchange traded funds) are used in the traditional space.” Merrills adopts a philosophy of full transparency, with all weights and algorithms disclosed to investors. The management fee is generally less than 100bps, depending on investment size, with no performance fee. Bowler said that hedge fund fees were still high in the US, with the often-quoted ‘2 and 20’ – 2 per cent base and 20 per cent performance above a hurdle – still the norm. The Merrills platform is currently short the S&P 500, long the MSCI EAFE index, long emerging markets, slightly short the US dollar index and long the Russell 2000. Because of its long/short activities and the index is fully funded, the allocation has a high cash component – currently about 60 per cent – to ensure the risk of the index is the same as the risk of the underlying exposures. Merrills also offers a different type of methodology called ‘mechanical trade replication’, which involves direct implementation of certain hedge fund strategies. The two which Merrills has launched so far are the Merrill Lynch Equity Volatility Arbitrage Index and the Merrill Lynch FX Arbitrage Index. Both involve systematic execution of common hedge fund strategies.