After being among the first banks in 2006 to introduce a hedge-fund replicating strategy in the form of an index (the Merrill Lynch Factor Index - see Structured Products, January 2007) and raising $200 million from the strategy, Merrill Lynch this year launched a Factor Index Fund based on an open-ended Ucits III-compliant structure domiciled in Luxembourg.
The European Union's Ucits III directive permits funds to be passported across EU borders, extending the use of derivatives to include over-the-counter and listed derivatives, and allowing them to be embedded in transferable securities. Merrill is one of a handful of structured products providers that has built a fund platform to distribute Ucits III-compliant funds.
Since the launch of the Merrill Lynch Factor Index (MLFI), dozens of hedge-fund replication strategies have appeared, designed to emulate hedge fund beta performance. However, only a few of these have been adapted in a Ucits III-compliant format that allows the product to be passported and marketed to retail investors in the EU.
The MLFI strategy has generated a year-to-date return of 7.57%, outperforming the other investable active hedge fund indexes, such as the HFR Hedge Fund asset weighted index (with a year-to-date return of 4.02%) and the Credit Suisse/Tremont index (with a year-to-date return of 3.52%). The MLFI Index consists of six liquid market indexes: the S&P 500 total return, Russell 2000 total return, MSCI EAFE net total return, MSCI Emerging Markets Free TR, US dollar and one-month US dollar Libor indexes.
Each month, the weightings of each component are rebalanced using a rules-based algorithm. Exposures to market measures can be positive (long) or negative (short), except for the MSCI Emerging Markets Free TR, which can only be long.
Other than hedge fund replication strategies, this year has also seen the release of products linked to implied volatility as equity market volatility has become an attractive source of performance for products (see Structured Products, September 2007).
A huge amount of variety exists among providers that have attempted to package the strategy which can offer exposure to the short-dated implied volatility on equity market indexes. Merrill is one of the few that have launched an open-ended Ucits III-compliant product based on its Forward Equity Variance Rolling (FEVR) strategy.
The FEVR strategy is a calendar spread in variance with equal variance notional. It combines a long position in six-month variance with a short position in three-month variance, effectively giving investors long exposure to three-month variance forward starting in three months. The strategy combines the forward variance swap positions with a cash account earning Euribor, which fully collateralise the position. There is no cap on the implied volatility.
The strategy has been used as an underlying for certificates distributed in Germany, producing returns of 14.18% since January. In September, the bank began trading the ML Euro FEVR Fund, which has been marketed in France and Germany. The fund provides an efficient hedge for an equity portfolio and features extremely negative correlation with the DJ Eurostoxx 50, says Pierre Mendelsohn, London-based managing director and head of Merrill Lynch's structured products group for EMEA.
The bank was also quick off the mark with the Merrill Lynch Global Bonus Fund, which has been manufactured to pre-empt Germany's forthcoming flat-rate taxation regime for all investment products, including certificates and funds. The fund is still being marketed in Germany, and is due to close this month. The Ucits III-compliant five-year fund is linked to a basket of equally weighted indexes: the DJ Eurostoxx 50, the S&P 500 and the Nikkei 225. At maturity, if none of the indexes has traded below 50% of its initial value, the investor will receive the maximum of 40% of the performance of the basket in addition to his initial capital. But if any of the indexes trades below 50% of its initial value, investors will receive 100% of the capital plus the performance of the worst-performing index.
"It's a new structure in response to tax (Abgeltungssteuer)," says Lars Fahnenbrock, Credit Suisse's Frankfurt-based head of investment solutions, adding that the product has generated positive feedback from investors.