Merrill Lynch tries to replicate forex hedge fund strategies

The New York firm said Thursday that it's in the process of developing a tool designed specifically to replicate the foreign exchange investment strategies of hedge funds.

The tool, which isn't yet available for client use, is aimed at helping clients better access the foreign exchange market as an asset class, or hedge underlying exposure to currency funds using trading strategies largely employed by hedge fund portfolio managers.

The initiative, called ML FX Clone, is the first such clone to be attempted explicitly in the foreign exchange arena, according to Merrill.

The tool tries to "replicate the performance of currency portfolios by loading up on particular strategies that are commonly employed by (hedge fund portfolio) managers," Alex Patelis, head of global foreign exchange and local currency strategy at Merrill Lynch, said in a research note.

Merrill is employing three trading strategies in order to replicate the activity of these fast-moving funds: a momentum strategy, in which managers employ trend-following techniques, a carry strategy in which managers borrow in low-yielding currencies in order to invest in higher-yielding units, and a U.S. dollar strategy in which managers take positions in the dollar versus other currencies.

Interestingly, according ML FX Clone backtesting, the momentum strategy most closely correlates with the results of widely-used hedge fund performance indices, including the FX Parker index.

Merrill Lynch clients can currently access the foreign exchange market by implementing their own trades, either with or without the help of Merrill's currency research trade recommendations, or by investing in a number of foreign exchange products that the firm's structuring desk has created.

The new tool, which is currently still only a research initiative and is being developed by the firm's foreign exchange strategy team, is "part of an extensive body of academic literature showing that hedge fund performance can be replicated using a variety of approaches," Patelis noted, which may make it increasingly difficult to justify paying higher fees for active hedge fund portfolio management.