Merrill Lynch yesterday introduced ML FX Clone, a methodology for replicating hedge funds’ foreign exchange (FX) strategies that will help investors to better understand and ultimately access the FX markets with greater ease and at lower cost. ML FX Clone is designed to replicate the most widely-used FX investment styles followed by active portfolio managers.
Merrill Lynch research analysts have designed ML FX Clone for investors who wish to gain exposure to FX as an asset class or who wish to hedge underlying exposure to currency funds. ML FX Clone also helps investors to separate manager alpha – how much the portfolio manager contributes to returns – from beta – how much market factors contribute to returns.
“Our replication strategies offer attractive returns and diversification benefits similar to those of broad currency portfolio manager indices,” says Alex Patelis, head of global foreign exchange and local currency strategy at Merrill Lynch. “However they are more transparent, have greater liquidity, little manager risk, and have potentially lower trading and transaction costs.”
ML FX Clone was developed to help make foreign exchange a more accessible asset class by providing more information and insight on the three investment strategies that FX portfolio managers most commonly use. The first strategy is momentum, in which a portfolio manager identifies and follows market trends. The second strategy is the carry trade technique, in which investors buy currencies from economies with higher interest rates and sell those from economies with lower interest rates. The third strategy is the U.S. dollar method, in which investors take a view on a currency relative to the value of the U.S. dollar.
Merrill Lynch analysts have established a high correlation between the ML FX Clone model and existing benchmark currency market indices, including the Parker FX index. This indicates that the process can capture much of the variability in the returns achieved by different portfolio managers.
Backtesting analysis shows that ML FX Clone achieved an average annual return of 9.1% with a 0.82 Sharpe ratio, with only one year of negative returns since 1989, compared to 9.0% and 0.94, respectively, for the Parker FX index. Over the past three years, ML FX Clone has mirrored the underperformance of the Parker FX index.
Merrill Lynch analysts noted in an October 2006 report ‘Replicating Hedge Fund Returns, New Alternatives in Hedge Fund Investing’ that as the hedge fund industry matures and more active managers share and compete for available returns, justifying paying higher fees for active management may be increasingly difficult if similar strategies can be mechanically implemented at lower cost.