Interview With Deutsche Bank’s Thorsten Michalik: How The World’s First Hedge Fund ETF Works

Deutsche Bank (DB) Exchange Traded Funds - db x-trackers - is currently the fastest growing ETF provider in Europe. It offers hundreds of ETFs across 5 European countries and has just launched 5 ETFs that are traded on the Singapore Exchange. As of 14^th of April 2009 db x-trackers had more than 20 billion Euro Assets under Management (AuM).

In this DailyMarkets.com exclusive interview, we speak to Thorsten Michalik, head of db x-trackers at Deutsche Bank, and ask him about synthetic-replication ETFs and how an investor can get greater returns by using them. Thorsten also tells us about the exciting new Hedge Fund Index ETF that gives investors access to hedge fund performance, without the lock-in and large minimum investments.

Could you explain briefly the advantages of a synthetic-replication ETF over standard replicating ETFs?

The traditional ETF structure is based on the fund owning all or a representative sample of the underlying benchmark. This has worked well in the early stages of the development of the market. However, institutional investors are increasingly demanding greater efficiency and lower overall costs in the products that they hold and trade. This has led to the creation of a number of new ETFs which are based on holding a basket of stocks (equitiy or commodity ETFs) or bonds (fixed income ETFs) and a maximum 10% index swaps as opposed to directly holding the underlying index constituents.

There are a number of benefits to be had from an ETF structured via a the synthetic replication method and overall these types of ETFs have both significantly lower costs and tracking errors compared to traditional equity ETFs. Synthetic-replication ETFs remove the risks of managing dividend flows compared to the index being tracked meaning that the problems of cash drag and dividend receipt are no longer an issue. The same structure is also a more efficient means of replicating total return indices, especially with relationship to funds where dividends are sourced from a wide range of countries. Other costs that are faced by traditional ETFs include index turnover due to index changes, rebalances and corporate actions.

A basket of stocks or bonds plus a max. 10% index swap structure typically benefits a fund compared to owning the underlying equities due to the fact that the returns are based on the benchmark index. Effectively the index swap ensures that the ETF will have performance, before any management fees, at least matching the designated index. In essence all the risks and costs associated with running an ETF based on equities and measured against a total return benchmark are passed onto the provider of the OTC swap. This means that a synthetic-replication ETF by the very nature of the returns that it now receives is likely to be considerably more efficient than one based on the standard structure running the full basket of underlying equities without a swap.

The synthetic-replication ETF framework has expanded from just the equity universe and now covers ETFs in the fixed income, money market, commodity, currency and credit space. In Europe, 50% of new ETFs use index swaps to replicate the index performance.

So the main advantage of a synthetic-replication ETF is that they more closely mirror the underlying index?

Yes, the main benefits from synthetic-replication ETFs are low tracking error and certainty relating to costs, whilst investors also have the advantage of being able to take advantage of the liquidity in the underlying stocks. A good example would be for a broad index such as MSCI World. The underlying index has close to 1800 stocks, which an investor could own as a fully replicated portfolio. However, this would tend to incur significant transaction costs and would likely have substantial ongoing maintenance costs with respect to corporate actions, takeover activity, dividend reinvestment and quarterly index rebalancing. There are also multiple currencies to manage in the context of a world index.

What about an investor owning futures contracts instead of the underlying stocks?

Investors have long used futures baskets to replicate broad based benchmarks, but these also have constant ongoing costs with respect to futures roll, margins, execution risk and relatively high tracking errors. An optimal basket of 10 local futures gives a tracking error of 153bps. If investors wish to have greater operational efficiency by using fewer futures, the trade off is in the form of higher tracking error with, for example, four futures giving a tracking error of 234bps.

In contrast to this, the db x-trackers MSCI World ETF which is swap based can be expected to underperform its benchmark index by at most its total expense ratio of 45bps over the course of a year. In addition the tracking volatility is likely to be extremely low, with the tracking error of the db x-trackers MSCI World ETF having ranged from 1 to 3bps. Investors face similar levels of efficiency with synthetic-replication ETFs for broad benchmarks such as MSCI Europe and MSCI Emerging World. In the case of MSCI Europe a typical futures basket would have a tracking error of around 140bps, compared to 5bps for the ETF. With respect to the MSCI Emerging Market World benchmark, futures are generally inefficient with tracking errors as high as 541bps whilst the ETF on the same index has a tracking error of 4bps.

Since synthetic-replication ETFs significantly reduce tracking-error and limit the risk of counter-party default to 10%, is there any reason an investor should choose an Exchange Traded Note (ETN) over a similar synthetic-replication ETF?

There is no reason.

If the swap counter-party were to default, the maximum loss should be limited to a maximum of 10% of the Net Asset Value (NAV). Is there a chance that the assets held by the ETF could differ so significantly from the index composition that the loss could be higher than that 10%?

The monitoring and management of the counterparty exposure (max. 10%) is an integral part of the daily valuation and operational process for each ETF and is the responsibility of the investment manager which is State Street Global Advisors (SSgA). There are processes in place which ensure that the 10% UCITS limit is never reached and the exposure maintained at a lower level. This is done via the resetting of the swap which reduces the counterparty exposure to DB to zero.

Through this process, any gains made through the swap are effectively ‘banked’ through a payment from DB to the relevant ETF and the swap exposure to DB reduced to zero. The gains are then reinvested in the substitute basket thereby increasing the overall assets of the ETF.

The swap for db x-tracker on equity indices is reset when:

1. the counterparty exposure to DB in Equity ETFs reaches around 4 to 5% of the NAV of the ETF and/or
2. (ii) whenever there is a subscription/redemption at the fund level. This means that the 10% UCITS counterparty risk limit should not be reached and also due to frequent subscription/redemption activity, the counterparty exposure to DB is kept to a minimum.

At the end of February 2009 the average weighted counterparty risk for the db x-trackers equity ETFs was less than 2%. With regards to the money market ETFs the counterparty exposure is currently zero and the substitute basket comprises government bonds only.

Under the unlikely event that the swap counterpart defaults - SSGA would start and sell the basket of stocks the fund holds and the investor would receive cash. It’s difficult to say whether the potential risk could be higher than 10% as the swap exposures differ from fund to fund and day by day. Plus it is difficult to say how volatile the markets would be at any given day.

Tell us a bit about the tax advantages of using an ETF provider such as db x-trackers that has offices throughout the world and can claim tax benefits on the dividends yields it receives in those countries.

All of the db x-trackers ETFs replicate the underlying index synthetically using a basket of stocks or bonds plus an index swap (see earlier). One advantage of this approach is that all sources of tracking error can be eliminated to ensure there is perfect index tracking before accrual of management fees.

Another advantage of the synthetic replication is that it allows for enhancements to be passed through into the returns of the index swap which means that the impact of management fees can be partially or fully offset. These enhancements can come from two sources:

1. Lending of the underlying index constituents and
2. better tax treatment of dividends paid on the index constituents.

For example, the db x-trackers Euro STOXX 50 ETF outperformed the underlying index by 1.08% (since launch on 4 January 2007 to 27 February 2009), after taking into account the accrual of the annual all-in fee of 0.15%.

(click for larger image)

The chart below illustrates how the enhancement works in relation to the db x-trackers MSCI Europe TRN Index ETF since its launch in January 2007. The chart shows the performance of the ETF relative to the Index (100 line) and each Phase is described below:

Phase 1: Here the fund is accruing the management fee (0.30% pa) from January 2007 to April 2007 resulting in an underperformance versus the index.

Phase 2: The underlying stocks in the index are paying dividends which results in greater potential for enhancements and this is reflected in an uplift in the performance and the ETF to starts to outperform against the index.

Phase 3: The number of stocks in the index paying dividends reduces and any enhancements begin to be offset by the accrual of the management fee. The point marked X on the chart represents the one year anniversary of the ETF and at this point there is zero tracking difference between the performance of the ETF and the Index. In other words, the management fee of 0.30% pa has been offset by the enhancements being passed through resulting in perfect index tracking.

Phase 4: Repeat of Phase 1 described above.

Phase 5: Repeat of Phase 2 described above.

(click for larger image)

During the current financial crisis, a lot of investors have shifted to money-market funds. Have the DB x-trackers money market funds seen more investors moving into them?

There has been an explosion in fixed income ETF assets under management (AUM) in Europe, with 250% growth in less than two years, of which 44% of growth can be attributed directly to db x-trackers.

db x-trackers, Deutsche Bank’s Exchange Traded Fund platform, raised €10bn AUM in fixed income ETFs between June 2007 and February 2009. Since June 2007 the market in fixed income ETFs has seen 250% growth in Europe, as AUM climbed from €9bn to €31.7bn at the end of February 2009.

db x-trackers, Deutsche Bank’s Exchange Traded Fund (ETF) platform, accounted for 44% of fixed income ETF growth in Europe over this period. Since June 2007 db x-trackers have raised AUM of more than €10bn, seeing an average asset accumulation in fixed income ETFs of €500m per month.

And which is the most popular db x-trackers money-market fund?

Money market ETFs have also enjoyed phenomenal growth since their introduction in Europe by db x-trackers in June 2007 with the Deutsche Bank EONIA (European overnight index average) ETF. The EONIA ETF has accumulated more than €6.5 bn AU, which represents more than 20% of the European fixed income ETF market. The db x-trackers EONIA ETF is the largest ETF in Europe in terms of AuMs and trading turnover furthermore it has the tightest spread among all ETFs in Europe

Deutsche Bank has just launched a hedge fund ETF. Hedge funds have typically been a pretty exclusive club with large minimum investments and out of reach for most investors. Tell us a bit about this new ETF.

Deutsche Bank has listed last week the world’s first hedge fund index- linked Exchange Traded Fund (ETF), providing liquid, exchange e-tradable access to the hedge fund asset class.

The hedge fund ETF is linked to the db Hedge Fund Index - a proprietary Deutsche Bank index that captures core hedge fund strategies (equity hedge, market neutral, credit and convertible, systematic macro and event driven) in a liquid and transparent format. Each strategy is reflected by a sub-index which is represented in the main index according to recognised industry asset weightings.

Each sub-index is linked to the performance of its constituent hedge funds sourced from Deutsche Bank’s leading hedge fund managed accounts platform. The platform is a risk controlled, liquid and transparent investment platform representing a broad spectrum of hedge fund strategies. The funds on the platform are run by Deutsche Bank entities with external third party hedge fund managers appointed to manage each underlying portfolio.

The structure of the hedge fund managed account platform means that all the funds in the ETF index are subject to Deutsche Bank’s continuing daily risk monitoring process. In addition, investors have a higher level of transparency than with traditional hedge fund products. For investors wanting access to hedge fund returns, this ground breaking ETF based on our managed account platform offers unprecedented transparency and liquidity.

This new product again demonstrates Deutsche Bank’s capabilities as the leading innovator in the European ETF space. For the first time, investors will have liquid access to the hedge fund industry. Market participants will also be able to base their financial products on the ETF, as Deutsche Bank will be the market maker and will offer two way prices on and off the stock exchange.

All hedge funds on the managed account platform are Jersey unit trusts listed on the Irish Stock Exchange and managed and administered by legally separate Deutsche Bank affiliates. Third party hedge fund managers are sub-contracted to each platform fund as a trading advisor and their responsibility is to manage the portfolio for a given fund. The platform is a risk-monitored and transparent framework benefiting from the following:

Position level data for each fund for Deutsche Bank’s Risk Monitoring group Daily Risk Monitoring by Deutsche Bank to ensure each trading advisor complies with the agreed investment guidelines for each fund; Third party regulatory oversight by the Irish Stock Exchange and the Jersey Financial Services Commission Fund pricing independent to the Trading Advisor Auditing by KPMG.

The index level of the db Hedge Fund Index is independently calculated on a T + 3 business day DBIQ. The index is calculated on a total return basis and started on 31 December 2008. Index levels are posted on Bloomberg and on the DBIQ website (https://index.db.com).

The ETF on the db Hedge Fund Index has a management fee of 0.90% p.a., is listed on the Frankfurt Stock Exchange and Euro Hedged. The ETF was listed on the 11.03.09 in Frankfurt. During the course of 2009 further listings in Europe are planned.

Thorsten Michalik was appointed head of the global exchange traded funds of Deutsche Bank in 2006 and is responsible for its product development, sales and marketing.

Thorsten joined Deutsche Bank’s equity derivatives team in 2000.He became the spokesperson in 2001 sharing comments on behalf of the Bank on warrants and certificates investments. In 2004, Thorsten moved to Asia and led the warrants and certificates business for Deutsche Bank in Hong Kong and Singapore.

Prior to joining Deutsche Bank, Thorsten served a bank in Switzerland in various roles including trader for foreign exchange warrants and marketing head of warrants and certificates.

Thorsten holds a Degree in Business and Management Administration from the Polytechnic of Constance, Germany. He is a licensed dealer of Deutsche Securities Asia Limited in Singapore

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