One of the major benefits of the rise of ETFs is that they have given smaller investors access to a wide array of asset classes and strategies that were previously about as accessible as the 33rd installment of the America's Cup. While commodities, currencies, and options and hedge fund strategies aren't for everyone, we think that ETFs tracking these categories can be good diversifiers in the portfolios of those willing to take the time to understand what they are and what they are not.
Here, we will take a closer look at the db X-Trackers Hedge Fund Index ETF. At present, this is one of just two ETFs available in Europe that give investors direct access to hedge fund strategies--the other being the recently launched Marshall Wace Tops Global Alpha ETF. However, there are others in the works (specifically, Qbasis's Futures Fund ETF, which is slated to launch later this year) and we think that it is important that investors understand how these funds work and the role that they might play in a portfolio before deciding whether or not to jump in.
db X-Trackers Hedge Fund Index ETF: What it is
A way to gain access to a basket of hedge funds: The db X-Trackers Hedge Fund Index ETF uses synthetic replication techniques (it’s a swap-based fund) to give its owners exposure to the performance of the db Hedge Fund Index. The index itself is comprised of five separate indices that each track common hedge fund strategies: equity hedge, market neutral, event driven, systematic macro, and credit & convertible. The broad index weights these five sub-indices according to industry-level allocations based on data from Hedge Fund Research Inc. and re-balances quarterly (see this table for recent allocations). At the sub-index level, each category has a minimum of five component hedge funds that adhere to that particular sub-index's strategy, the funds are equally weighted within the sub-index and also rebalanced on a quarterly basis. This structure provides diversification across strategies and individual managers, making the fund less susceptible to bad bets by an individual fund or within a given broad strategy.
Click here for an illustration of the db x-trackers Hedge Fund ETF Structure and the components of its index.
Pricey: The ETF charges investors a total expense ratio (TER) of 0.90% per year. While at first blush this may seem like a steal, it is important to understand that the returns on the underlying index are net of the component funds' fees, which for a typical hedge fund can include a 2% annual charge on assets under management and a 20% cut of any positive performance. Thus, the explicit costs borne by someone investing in the ETF (bid/offer spreads, trading commissions, the TER) reflect just a small portion of the true price of admission to what is a costly underlying investment strategy.
An attractive diversifier: The appeal of most hedge fund strategies is that they seek to produce uncorrelated returns, making them a great portfolio diversifier. To this effect, the db X-Trackers Hedge Fund Index has had a solid track record. According to Deutsche Bank data, the index posted annualised returns of 3.29% for the three year period ending 11 March 2010. This compares favourably to respective performances of -5.38%, -4.37%, and -7.72% for the MSCI World, S&P 500, and Euro STOXX 50 total return indices. The index achieved these returns while exhibiting a level of volatility similar to treasury securities and representing a fraction of that experienced in global commodity and equity markets. Add in low correlations with most broad equity, fixed income, and commodity indices, and the index (and, by proxy, the ETF) has the potential to be a solid diversifier in a balanced asset allocation.
A liquid alternative to a direct hedge fund investment: As compared to a direct investment in a hedge fund, an investment in the db x-trackers Hedge Fund index ETF is ultra liquid. Many hedge fund investors who tried to pull their investment during the recent bout of market malaise were turned back by managers that had reserved the right to suspend redemptions or had pre-specified lock-up periods. An ETF boasting intraday liquidity is an attractive alternative to those fretting over barriers to entry and exit such as minimum investment requirements, redemption restrictions, and redemption fees.
Not only is the db x-trackers Hedge Fund Index ETF itself extremely liquid relative to a direct hedge fund investment, but its hedge fund components are also quite liquid relative to their peers. Deutsche Bank has designed the index such that hedge funds that put redemption restrictions in place are excluded from the sub-indices. More liquid constituents wrapped into an ETF with intraday liquidity make for a vehicle that eliminates many of the concerns associated with entering and exiting a hedge fund investment. However, as with any security, liquidity is usually most abundant when it is least needed and nowhere to be found when you desperately want a way out. While this fund's liquidity is certainly a vast improvement over some direct hedge fund investments, that's not to say it cannot be subject to its own constraints. You may only be able to sell at a discount during periods of panic in the market when few market makers or arbitrageurs have ready capital.
What it is Not
Fully Transparent: While db x-trackers provides full detail on how the db Hedge Fund Index is constructed and works closely with authorised participants to ensure that tracking error on the secondary market is minimised, this fund will never be nearly as transparent as the vast majority of its ETF brethren. Investors will never know on a security-by-security basis exactly what the index's constituents might be (you will, however, know the weighting of the various sub-indices and their component funds). Full transparency is one of the hallmarks of the ETF category and will inevitably be lacking here.
A Top-Scorer: Because the index utilises stringent selection criteria in picking its component funds, notably with regards to the funds' liquidity, it will be less likely to post the type of jaw-dropping returns that are the stuff of hedge fund headlines. Some of the best-performing hedge funds, by virtue of their superior track record, are able to put into place some of the aforementioned gates and liquidity constraints that prohibit them from being included in the index. Given the exclusion of some of the hedge fund world's top performers, and the diversification effects inherent to an index tracking a minimum of 25 different funds following five different broad strategies, the db x-trackers Hedge Fund Index ETF is unlikely to generate the kind of mind boggling returns that many (falsely) believe are commonplace in the world of hedge funds.
For Everyone: An investment in the db x-trackers Hedge Fund Index ETF is certainly not for everyone. On the plus side, it offers easy access to a strategy that has proven its worth as a good diversifier in a balanced portfolio. On the minus side, it is costly and lacks the level of transparency that is one of the hallmarks of the ETF category. Ultimately, we think that this fund can play a steady role in a balanced portfolio for those willing to accept its risks and limitations.
