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Merrill Lynch launches volatility arbitrage index to replicate hedge strategy

Date: Friday, February 9, 2007
Author: Hedgeweek.com

Merrill Lynch has launched a volatility arbitrage index that seeks to replicate the returns of an S&P 500 volatility arbitrage strategy employed by many actively managed hedge funds. The creation of the index is seen as paving the way for investible products such as exchange-traded funds that track hedge fund performance.

The Merrill Lynch Equity Volatility Arbitrage Index, which is quoted intraday on Bloomberg under the symbol MLHFEV1, uses rules to govern the investment process and eliminates the fees associated with active management.

According to Merrill Lynch, simulated back testing of the Equity Volatility Arbitrage Index has outperformed most major global broad-based investible and non-investible hedge fund benchmark indices.

Moreover, the firm says, the strategy returns were negative in only three quarters over the past 18 years. The source of this strong performance is the high demand for S&P 500 index volatility relative to supply, a structural imbalance that has persisted for decades.

'Using rules to avoid the cost of active hedge fund management is the same principle that helped passive index funds such as ETFs gain market share from actively-managed mutual funds,' says Heiko Ebens, head of the Americas equity derivatives research team at Merrill Lynch. 'Additional distinct benefits of this style of investing are complete transparency, and the elimination of both style drift and manager risk.'

The Equity Volatility Arbitrage Index is the first in a series of hedge fund replication indices that Merrill Lynch Research plans to launch in order to implement mechanically strategies commonly employed by actively managed hedge funds. Merrill Lynch's synthetic hedge fund research unit has identified arbitrage opportunities in other asset classes that lend themselves to a rules-based approach.

Says Ebens: 'We find that some mechanically executed arbitrage strategies historically have outperformed active hedge fund benchmarks, not only because of the reduction in fees, but also due to the quality of the investment strategy.'

Merrill Lynch research analysts first noted in a report last October, entitled Replicating Hedge Fund Returns: New Alternatives in Alternative Investing, that as the hedge fund industry matures and more active managers share and compete for available returns, it may be increasingly difficult to justify higher fees for active management if similar strategies can be implemented mechanically at lower cost.

The report outlined two methods for creating synthetic hedge funds, to replicate hedge fund benchmarks with a dynamic portfolio of liquid assets, and to execute strategies similar to those employed by active hedge funds.

The first method has been the subject of extensive academic research and has been recently implemented by industry participants. The second method, the basis for the Merrill Lynch Equity Volatility Arbitrage Index, does not aim to track hedge fund returns, but rather invests in the same assets.