Looks Like an ETF, Acts Like a Hedge Fund

05/06/2009 12:06 pm EST

Focus: ETFS

Scott Burns

Director of ETF Analysis, Morningstar, Inc.

Scott Burns, Morningstar’s director of Exchange Traded Securities Analysis, and analyst Bradley Kay like a new ETF that mimics hedge funds’ strategies—without the huge fees.

IQ Hedge Multi-Strategy Tracker ETF (NYSEArca: QAI) seeks to match hedge fund index returns with low correlation to traditional assets and little risk.

Though we are still unsure if this fund can deliver on its promise of low-risk returns with low correlation to existing investments, it could be a useful holding for investors willing to take a chance on a new strategy with a solid academic pedigree.

Hedge funds have some superior skill at allocating speculative capital across markets, but most of these common trades could be replicated using indexes available to any investor today. IndexIQ established their IQ Hedge Multi-Strategy Index to take advantage of this research and provide returns resembling those of major hedge fund indexes by replicating six different common fund strategies, using ETFs to match the calculated risk exposures of the hedge funds. An investment that has low correlation with the stocks and bonds that already dominate most investors’ portfolios would provide better risk reduction.

The results of the IQ Hedge Multi-Strategy Index have been mixed thus far. The index has shown a five-year history of low vola­tility and reasonable returns, which we are fairly confident it can maintain in the future due to strong results using similar methods.

Unfortunately, this investment has not lived up to expectations as a diversifier. Over the past five years, it has shown a moderate correla­tion with US equities around 0.7, but a much higher 0.85–0.90 correlation with international equities, both emerging and developed markets.

Its substan­tial bond exposure over time also led to a sizable 0.5 correlation with the US bond market. So, even though this index has shown very promising returns relative to its low risk thus far, its benefits in tamping portfolio risk would be limited.

Given the promise of the strategy, it may seem surprising that the correlations with traditional asset classes are so high. However, IndexIQ has had to limit its risk exposure to those easily replicable using liquid ETFs. Thus, it should come as no surprise that the index returns mostly match their building blocks. As the IndexIQ model expands to encompass commodities, volatility, and other alternative asset classes commonly used by hedge funds, it may yet deliver on its promise of lower-risk, low-correlation returns for a fraction of hedge funds’ cost.

This new ETF is among the most expensive we have seen thus far, with an all-inclusive expense ratio of approximately 1.09%. But this pales in comparison to the exorbitant fees of hedge funds of funds, which average more than 6% a year.

[IndexIQ] has yet to break free from high correlations with equities and bonds. Still, this fund has great potential, and we believe hedge fund replication could excel sometime in the future as the investment universe of liquid ETFs expands.

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