Aiming squarely at investors disappointed in the performance of global and international equity funds that have been eroded by the high-flying Canadian dollar, Merrill Lynch Canada Inc. recently beefed up its “Accelerator Securities” series of notes.

In July, Merrill unveiled a new series whose return is based on the performance of a basket of international stock indices. This series joins several others that have been launched since October, all of which are tied to the performance of foreign market indices such as the Standard & Poor’s 500 composite index or Japan’s Nikkei 225.

What is appealing to currency-conscious investors is that the Merrill notes are hedged to protect against the potential negative impact of foreign currency exposure. There are C$ and $U.S. versions of the series. If investors believe the greenback is headed up against the C$, they can buy notes denominated in US$.

Then there’s the “accelerator” feature that applies to all series: if the underlying indices rise in value over the notes’ duration (which is typically six to seven years), a multiplier is applied to juice up the returns. If the indices lose value, their losses are not “accelerated.”

“We are trying to offer something that is more compelling than a global equity exchange-traded fund and more compelling than a global equity mutual fund,” says Scott McBurney, head of private client strategic solutions in Toronto. “These are meant to be ‘long’ global equity investments.”

In the risk/return spectrum, the notes are speculative in nature and just as risky as ETFs and global equity funds in that they can incur losses. On the plus side, however, the accelerator feature offers the potential to magnify gains, thanks to some financial engineering and the investor’s patience.

Buying a C$ note entitles investors to a 140% acceleration factor; US$ notes offer a 160% acceleration factor. These factors are based on a complex blend of interest rates, dividend yields and market volatility, says McBurney: “The market dictates what we can offer.”

How does an accelerator-style note work? If you invest $2,000 in a C$ note and the basket of indices rises 100% over the life of the note, you’ll get 1.4 times the return on those indices, or $2,800. Combined with the initial $2,000, the total return is $4,800.

For holders of the US$ note, assuming the same basket of indices, the return on a US$2,000 investment would be US$3,200 after six years, for a total value of US$5,200.

If the basket of indices drops in value by 25%, then the initial $2,000 investment would be worth $1,500 after six years. In the unlikely event that the indices totally collapse, there is some comfort in knowing the investor can’t lose everything as there is 20% principal protection.

Investors are not entitled to receive dividends paid on the stocks in the underlying indices, nor are they entitled to any voting rights. If investors decide to sell the notes prior to maturity, they will be subject to capital gains taxes, if applicable.

Minimum investment is $2,000. Although there is a 4% sales commission, there are no ongoing management fees.

There is a secondary market for the notes. Each night, Merrill posts the prices of its products on its Web site, http://ca.structured

solutions.ml.com. (Go to “Previous Issues” under “Structured Solutions.”)

Merrill introduced Global Equity Accelerator (CAD) Notes, Series 1, in October, followed by Series 3 in February and Series 4 in June. The US$-based notes were also launched in October 2005, February and June. In December, the firm launched Japanese Equity Accelerator Series 1, linked to the Nikkei 225, in a C$ version.

In May, the firm introduced International Equity Accelerator (CAD) Series 1, plus a US$ version. International Equity Accelerator (CAD) Series 2 was launched in July. About $113 million in total has been raised from the sale of these notes thus far.

These products are designed to be a substitute for ETFs or mutual funds in actively managed accounts, says Kevin Nash, Merrill’s head of marketing, private client strategic solutions. The fact that negative returns are not accelerated is a big plus, he says. “If the markets are up, you will do better. If the markets are down, you will do no worse.

“Most active [mutual fund] managers say they try to beat the benchmarks. Some do, some don’t. This is a guarantee that we will beat the benchmarks by 140%, or 160% if you buy the US$ version,” says Nash.

@page_break@The notes are modelled after similar ones offered by Merrill’s European and Asian operations. But their made-in-Canada features consist of different sets of indices and currency hedging back into the loonie.

For example, the Global series of notes is linked to a basket that consists of 33% S&P 500 index, 33% Dow Jones EURO STOXX 50, and 33% Nikkei 225.

The International series is aimed at investors who do not want U.S. exposure and comprises a different mix: 25% Dow Jones EURO STOXX 50 Index, 25% Nikkei 225, 25% FTSE 100 and 25% S&P Asia 50 index.

The notes are issued by Merrill Lynch Canada Finance Co.

“We get a lot of feedback that Canadian investors have been frustrated with the performance of many global equity funds. There are examples in which some managers have outperformed the benchmarks. But, generally speaking, that hasn’t been the case,” says McBurney.

Although some managers have been known to outperform, he adds, it’s difficult to pick the manager who will outperform for the next five years and know when to exit the fund and pick the next outperformer.

Nash adds that current conditions in the derivatives market are conducive to the development of such products. “Low volatility, relatively low interest rates, and dividend yields make this trade possible,” he says, noting that institutions enter into such trades as a substitute for futures and ETFs. “Essentially, we are bringing it down to the retail client so he or she can participate.”

Indeed, Merrill Lynch Canada has developed a “significant” customized business, says McBurney, by selling many Accelerator products to institutional and ultra-high net-worth individuals. “We have done some very sizable transactions. But this is an institutional-class product that we are making available to retail investors.”

Will the stabilization of the loonie effectively make these products less attractive? Nash says investors have the option to buy the US$ versions and get US$ exposure and higher acceleration. “You buy the product that suits your view,” says McBurney. “That’s why we offer both.”

However, mutual fund expert Gordon Pape, Toronto-based publisher of the Internet Wealth Builder, cautions that these products have up to 80% downside. “If the markets tank, you’re in trouble,” he says.

But, McBurney notes, the product is designed to compete with ETFs and global equity funds, which have no downside protection at all: “Our products have 20% principal protection to make them eligible for RRSPs, which was based on the view of our tax advisors.”

The currency hedging factor comes at a stiff price, says Pape, noting the 20% advantage in the acceleration factor that the US$ products have over the C$ ones. “If it were me, I’d buy the US$ note, on the assumption there will not be that much in the difference between the two currencies over the next six years. Otherwise, you’re giving up [a part of] of the accelerator,” says Pape, adding it’s unlikely the C$ is going to increase against the US$ by the amount implied in the accelerator. “There is a real incentive to go for the US$ notes.”

Pape acknowledges that Merrill has created a secondary market but is not obligated to do so. Moreover, even if investors can exit, Pape warns, it could be at a disproportionately low price because there is no active market: “Unlike a mutual fund, you won’t get out at NAV.”

But, McBurney notes, Merrill conducts daily secondary markets in all its public structured-note offerings around the world: “Without making a secondary market, we would not have been as successful in our global structured-products operations. This speaks for the liquidity of the notes that we market.” IE