The mutual fund industry is learning that exchange-traded funds are a force to be reckoned with. Will hedge funds—which have long used ETFs to their own trading ends—soon join them in that school of hard knocks?
Merrill Lynch today unveiled its Merrill Lynch Equity Volatility Arbitrage Index, a tracking index with intraday quoting that seeks to replicate a volatility arbitrage hedge fund’s returns. According to Heiko Ebens, the head of Merrill’s Americas equity derivatives research team, a number of investible products, potentially including an ETF, could license the index.
“There are certainly a number of platforms that could link to this index,” he said. “Essentially, the index has the look and feel of the S&P 500. The design is such that it feels like any other index out there.”
The index, which is quoted on Bloomberg under the symbol MLHFEV1, certainly has some attractive features compared to hedge funds, most notably cost.
“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,” Ebens said.
In addition, according to Merrill, back-testing of the rules-based methodology shows that the index would have regularly topped most major hedge fund indices. But unlike hedge funds notable for extremely active trading, the Merrill index will be rebalanced according to its rules only once per quarter. But the difference doesn’t faze 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,” he said. “We see ourselves where ETFs were 10 years ago: with a realization that a rules-based approach can gain market share on actively-managed money without requiring an active manager to lower cost.”
According to Ebens, the index is the first of a rules-based series of indices covering major hedge fund strategies. Further arbitrage strategies in other asset classes are likely.