Marco Montanari of Deutsche Bank discusses some of the trends in hedge fund ETFs, how they can be structured to suit investors, and considerations for buyers of this product.

Date: May 2011

Tags: ETFs, Hedge funds, Transparency, Liquidity

• Using UCITS 3-compliant funds, product providers can meet requirements for hedge fund ETFs in terms of diversification of risk, limitation of counterparty risk and due diligence
• It is possible to give real exposure to hedge funds via ETFs – despite the liquidity constraints and other issues – by internalising the risk analysis that the managers are doing
• Investors need to understand that they will not get the exact hedge fund returns, even if the ETF is replicating known manager strategies
• More and more hedge fund ETFs are likely to appear in the market given the clear trend from a pure active, long-only management approach towards index and alternative asset management

In the last few years, and even during the financial crisis, the hedge fund industry has generally outperformed other asset classes from a beta-returns perspective, said Marco Montanari in an interview.

This is something many individuals have ignored given some of the high-profile problems with a few specific hedge funds, he explained.

The challenges in the hedge fund space relate to the lack of liquidity, which investors are less willing to accept following the crisis, and also the openness of the structures, said Montanari.

As a result, market players have tried to put in place a solution through UCITS 3-compliant funds.

Using this European-led regulation, Montanari said product providers can meet requirements in terms of diversification of risk, limitation of counterparty risk, due diligence and other key things.

Providing real exposure to hedge funds

According to Montanari, it is possible to give real exposure to hedge funds via ETFs – despite the liquidity constraints and other issues – by internalising the risk analysis that the managers are doing.

This means asking the managers to implement their asset allocation using Deutsche Bank as a prime broker or custodian, he explained, and therefore the bank becomes a risk entity in charge of the risk analysis.

This means the bank can verify that the manager really exists, and also can monitor that the UCITS regulations are being followed.

Considerations for investors in hedge fund ETFs

Montanari said investors need to understand that they will not get the exact hedge fund returns, even if the ETF is replicating known manager strategies.

This is because the manager might involve non-UCITS compliant strategies, and also because the investors are getting better liquidity than hedge funds can typically provide.

Yet the kind of proxy investors get to the real hedge fund industry has been very satisfactory, he said.

For high net worth individuals, Montanari said hedge fund ETFs can be effective given they might have the need for more liquidity, and they want to ensure they are investing in a robust structure without spending the three to six months required for due diligence to assess the underlying funds.

At the same time, these ETFs are offered in very diversified forms, he added, providing exposure to more than 40 different hedge fund strategies.

An evolving market

Montanari said that more and more hedge fund ETFs will appear in the market given the clear trend from a pure active, long-only management approach towards index and alternative asset management.

So having a product which combines alternative beta with indexing is becoming increasingly interesting to investors.