Does Hedge Fund Replication Work?

Just days after the stock market hit its March 2009 bottom, IndexIQ, a tiny index provider, launched its first exchange-traded fund, the IQ Hedge Multi-Strategy Tracker ETF (QAI). As far as attracting investors, the timing proved inauspicious. Most investors were shellshocked after witnessing the stock market plummet more than 50 percent in 18 months. However, inside the ETF industry, the fund’s hedge fund replication strategy drew much interest. In April, the ETF won Most Innovative ETF and its eponymous index won Most Innovative Index at the 9th Annual Closed-End Funds & Global ETFs Forum, the first time a single firm won awards in both categories.

It’s no wonder. Hedge funds are sexy. These aggressively managed portfolios use sophisticated strategies to generate market-beating returns, otherwise known as alpha. Also, they’re very exclusive. Called “mutual funds for the super rich” by Investopedia, hedge fund investors need to be accredited. This means investors must not only be knowledgeable, but they must have a net worth greater than $1 million and make a certain amount of money. Unlike mutual funds, hedge funds aren’t regulated, so they have the flexibility to invest in many kinds of assets.

Hedge fund ETFs like QAI were supposed to solve all that. Democratize the space. Lower costs. Increase transparency.

It was “hedge funds for the rest of us.”

But do they deliver?

Now that the IQ Hedge Multi-Strategy Tracker and its brother, the IQ Hedge Macro Tracker ETF (MCRO), have passed their first birthdays, it’s possible to perform data comparisons to see if they actually deliver. Do these funds provide the pattern of returns that investors want when accessing the hedge fund space?

The first thing one needs to know is that, contrary to conventional wisdom, hedge fund ETFs aren’t charged with maximizing return on investment. They follow the strategy of the original hedge funds, reducing risk and minimizing losses by shorting and holding a combination of asset classes not correlated to the broad market. Of course, reducing risk means dampening potential profits, which means when the S&P 500 Index goes straight up on a bull rally, hedge fund ETFs will lag the market’s returns.

And that’s exactly what happened for the 12 months ending June 30: When the S&P 500 leapt 14.4 percent, the IQ Hedge Multi-Strategy Tracker inched up 2.2 percent and the IQ Hedge Macro Tracker gained 3.9 percent.

“Nothing is designed to shoot the lights out,” said Adam Patti, chief executive officer at IndexIQ. “I look at stress periods in the market as where hedge funds should be doing well.”

The hedge worked during the second quarter of 2010 when the S&P 500 tumbled 11.4 percent into a market correction. QAI slid 2.6 percent and MCRO lost just 2.1 percent. The ETFs also reduced volatility for the six months ended June 30. The S&P fell 6.7 percent during that period, while the QAI and MCRO posted negative returns of 2.5 percent and 2.3 percent, respectively.

“They are trying to produce a return pattern of the average hedge fund,” said Kevin Malone, president of Greenrock Research, a Chicago research firm. “The reason to consider this is to get a return pattern different from stocks and bonds; better than bonds but not as good as stocks.”

Originally published in ETF Report. For the full story click here.

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