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Cloning comes alive

Goldman Sachs and Merrill Lynch have introduced investment products that deliver hedge-fund-like returns without the high fee burden.

The race is on to commercialize synthetic hedge funds. For the past few years, academics have been discussing the possibility of replicating hedge fund performance using composites of market benchmarks. But it is the most recent research, including a paper from Massachusetts Institute of Technology finance professor Andrew Lo and Jasmina Hasanhodzic, an MIT Ph.D. candidate -- first published in Institutional Investor's sister publication, Alpha ("Attack of the Clones," June 2006) -- that has finally spurred securities firms into action.

Goldman, Sachs & Co. and Merrill Lynch & Co. are the first two to put academic theories on hedge fund cloning to the test. Both have products that they contend can deliver hedge-fund-like returns without investments in hedge funds. Using factor models similar to those proposed by academia, their indexes analyze historical monthly hedge fund returns and use weighted baskets of market indexes to replicate them.

Goldman Sachs' Absolute Return Tracker relies on a pool of roughly 17 benchmarks -- including indexes related to equities, commodities, fixed income, credit and volatility -- and an unspecified, publicly available third-party database for its hedge fund returns.

The Merrill Lynch Factor Index is more transparent. Six total-return indexes drive the model: the Standard & Poor's 500, the Russell 2000, the MSCI EAFE, the MSCI emerging markets free, the U.S. dollar index and one-month LIBOR. For performance data, Merrill's product relies on well-known hedge fund benchmarks like the HFRI fund weighted composite index.

Steven Umlauf, who is in charge of new product development in Merrill's global markets division, says the Factor Index averaged a better than 90 percent correlation to hedge fund returns for the past ten years in backtesting. He says the tracking error -- the amount Merrill's index deviates from actual hedge fund performance -- has declined as the hedge fund industry has matured. Merrill Lynch believes the huge influx of money into hedge funds has made the market more efficient and is the reason the correlation between performance and the model portfolio has increased.

To create its clones, Merrill uses 24 months of performance data. Although the index is rebalanced monthly, Umlauf admits that the model can't immediately respond to rapid changes. "In really bad markets, like this past May, we initially underperform before we outperform," says Umlauf, a former finance professor at the London Business School who has spent the past 14 years working in equity capital markets and derivatives in New York, Tokyo and London. In May, Merrill's index fell 2 percent, compared with a 1.5 percent drop in the HFRI composite. But Umlauf says Merrill's index made up the difference, and then some, during the next three months -- though he wouldn't give specifics.

Merrill began running the strategy for its index, without any funding, in April 2006. Merrill Lynch Factor Index started taking investments four months later. Umlauf will not specify how much has been raised so far but says initial investments have come from private placements with institutions, including funds of hedge funds, insurance companies, pension funds and private banks. For January through November 2006, the Factor Index was up 11.2 percent, with 4.5 percent volatility -- the annualized standard deviation of monthly returns. By comparison, the HFRI was up 11.31 percent for the same period, with 4.9 percent volatility. So far the product, which is being offered worldwide, has taken an early lead over Goldman's.

Goldman's Absolute Return Tracker is only available in a limited number of European markets. The firm is still working to satisfy regulatory requirements for wider distribution in Europe, Asia and the Americas.

Low fees make synthetics appealing. Merrill says the total fees for its index are less than 1 percent. Goldman would not specify its costs, but its management fee is 1 percent. Provided the firms' returns can clone those of hedge fund indexes, investors could find these products an attractive alternative in a hedge fund world of 2 percent management fees and 20 percent performance fees. Still, not all investors are jumping on board.

The rearview-mirror approach of synthetic funds troubles Margaret Gilbert, a managing director at Greenwich, Connecticut­based hedge fund research and consulting firm Greenwich Alternative Investments. "You are investing on the basis of what happened a month ago, and a sudden severe movement in the market could send you the wrong way," she says. Gilbert prefers investable indexes -- which allocate money among the actual funds that make up these indexes -- because they capture managers' decision making in real time. Investable indexes operate like low-cost funds of hedge funds. Their critics, however, argue that they often don't include top-tier managers and that the fees tend to be higher than those of synthetic funds.

Merrill Lynch's experience so far suggests that the risk of firms' cannibalizing their hedge fund businesses by offering hedge fund clones is negligible. Initial investments in the Factor Index have primarily been new allocations. "This is going to popularize alternative investments even more," notes Steven Houston, who oversees Merrill's structured products marketing and origination in the U.S., Latin America and Canada.