Db x-trackers' new hedge fund ETF is a marriage of opposites in more ways than one. It combines the fastest-growing part of the fund management sector (ETFs) with the fastest-shrinking (hedge funds), the lowest- and the highest-fee investment products, and the funds most associated with liquidity and transparency with those renowned for opacity and restrictions on investor redemptions.

So how exactly does this ETF/hedge fund hybrid work, and what is likely to be its appeal to investors?

First, in contrast to the "hedge fund replication" ETFs and indices—Goldman Sachs's Absolute Return Tracker, and IndexIQ's Alpha Hedge Strategy fund, for example—which aim to "clone" hedge fund returns by creating proprietary trading models, Deutsche Bank's hedge fund ETF takes a simpler approach, actually investing in an underlying basket of hedge funds.

One immediate difference between the two approaches is that, whereas the proprietary algorithms that underlie the replication methodology are likely to produce a return that only approximates hedge fund index returns, the db x-trackers ETF aims to track the underlying funds' returns very closely, after taking fees into account.

It does this by what is known as a managed account programme, where the hedge funds concerned act as the external investment advisers to pools of assets under the control of the bank. Deutsche Bank has set up a number of Jersey-based mutual funds to do this, and the ETF's assets will be spread across them.

A key difference between the managed account approach and a typical investment in a hedge fund is that the managed account allows much greater levels of transparency and liquidity. While hedge funds have traditionally operated with monthly subscriptions and redemptions, the lockup of initial investments for periods of months or years, and gates on redemptions—limiting outflows to a certain percentage of fund assets per month, or even suspending withdrawals altogether in times of stress—the managed account offers flexibility and investor access to funds by centralising the provision of prime brokerage, custodial and administrative services, offering leverage (where appropriate), and having full legal control of the assets.

The 'No-Madoff Risk'

Also, as Fiona Bassett, director of Fund Derivatives at Deutsche Bank, explained, the independent NAV calculation and the ring-fenced account structure provided by the managed account platform removes any "Madoff risk"—the possibility that an external fund manager might be lying about fund returns. The ETF is also UCITS-compliant, a big attraction for many investors.

These aspects of the ETF hedge fund structure—greatly enhanced liquidity, its regulatory status and independent pricing and administration—are its key selling points.

The managed account structure and the promise of daily liquidity for ETF investors do, however, impose some constraints on the types of hedge fund suitable for the Jersey platform—those investing in less liquid areas of the market might be unsuitable. The degree of leverage that the underlying funds might operate with should also be subject to limits. Ultimately these will be Deutsche Bank's decisions to make.

Some observers have also pointed out in the past that "premium" hedge funds have tended not to agree to operate on managed account platforms, since operating a separate, segregated portfolio, with the likelihood of different liquidity and risk constraints, was not worth the extra effort.  As the more successful hedge funds tended to be oversubscribed, this was a position they could justify. 

However, the last year, with several dramatic fund collapses and a sustained period of poor performance, has seen a dramatic decline in managers' pricing power, with many more hedge funds now willing to go the managed account route.

The one-stop shop being provided by the bank's managed account platform to the hedge funds might also raise concerns about possible conflicts of interest. Prime brokerage has been a highly lucrative business for banks over recent years, and Deutsche Bank—which is responsible for selecting the hedge funds to make up the index, having chosen not to employ a third-party index provider—will be remunerated by the funds themselves from their day-to-day activities. 

In addition to securities trading, the use of stock borrowing and leverage by the hedge funds will all supplement the management fee coming from the ETF.

Where exactly will the assets of investors in the hedge fund ETF end up?

The ETF will track an index consisting of five constituent sub-indices, each tracking a different sector of the hedge fund universe. The percentage weightings allocated to these sub-indices reflects the predominance of each hedge fund strategy group in the worldwide hedge fund assets under management, as measured by Hedge Funds Research (HFR). This results in nearly 80% of the ETF's assets being devoted to the "equity hedge" and "event-driven" categories.

Within these categories there is scope for very disparate funds to be included. For example, the equity hedge category includes "a wide variety of investment processes, including both quantitative and fundamental techniques; strategies can be broadly diversified or narrowly focused on specific sectors and can range broadly in terms of levels of net exposure, leverage employed, holding period, concentrations of market capitalizations and valuation ranges of typical portfolios."

In other words, you don't know what you're going to get, except that, as it's a hedge fund, the manager is supposed to be trying to generate absolute returns in all market conditions. The db x-trackers fund factsheet gives backtested returns from the hedge fund index from 2003–2008, with the five years from 2003–2007 showing a return averaging around 10% a year, and a fall of 9.19% in 2008. 

Within each of the five sub-categories, a minimum of five fund managers will be represented, with the percentage allocation to each hedge fund within a category being rebalanced to an equal weighting each quarter.

The db x-trackers hedge fund ETF fund fact sheet, available to download from the firm's Web site, lists 32 initial hedge fund advisers across the five categories. Their funds' returns will provide the raw material for the index returns. Beyond the names of the firms involved, there are no specific details of how the advisers will invest, although Deutsche Bank points out that there is generally a good deal of publicly available information on the managers and their policies. 

When asked about the selection process for the funds, the bank said that it is looking for "well-known managers running liquid hedge fund strategies". It's worth noting the difference here with a discretionary fund-of-funds structure, where the fund selector would be looking, after conducting a due diligence process, to select the best managers available.

The ETF will charge an annual management fee of 0.90% per annum, putting it pretty much at the top of the range as far as tracker fund fees go. But then hedge funds have never been associated with cheapness, and the ETF is better value, in headline terms, than a traditional fund of hedge funds structure, where the fund-of-funds manager would typically add an extra 1%, plus a performance fee of 10%, over and above the underlying fund fees.

But it's important to be aware that the hedge fund fees haven't disappeared in the ETF, either. The hedge funds will charge their own, typically performance-related fees (which have historically run at "two and twenty"—2% flat, plus a 20% performance fee) to the Jersey funds which constitute the managed account. 

In other words, both the index and the ETF will be tracking the post-fee returns of the hedge funds. This means that, by the time you get down to the underlying stocks and bonds within the hedge fund ETF, you could easily be looking at a total annual fee approaching 3% (before even mentioning the performance kicker).

Ultimately, how the "hybrid" hedge fund ETF fares is likely to depend on which investor base you look at. Those (largely institutional) investors with an allocation available to make to "alternatives" (a catchall term encompassing nontraditional asset classes) should be attracted to the new fund, particularly to its enhanced trading liquidity and UCITS-compliant status. 

The more cost-conscious amongst ETF investors will probably need some convincing that it's worth paying hedge fund fees, plus a charge on top, for what is quite a complicated structure.