By: Andrew Saunders, Member of the Editorial Board of AllAboutAlpha.com, & Director, EFX Prime Services

In January the Wall Street Journal reported that ETF assets had crested $1 trillion. No longer is it simply another way to capture S&P 500 beta. It seems that every day there is an innovative new investment idea that is packaged in an ETF form. Joining us this month to discuss how ETFs play a role in an alternative investment portfolio is Adam Patti, CEO and Founder of IndexIQ . A lifelong entrepreneur, Adam has founded and run a number of companies in a number of business areas including marketing, technology and supply chain management. He was an early pioneer in ETFs, having led an indexing/ETF initiative involving two products while at Fortune Magazine, including the Fortune 500, the first fundamentally derived Broad-based index. His new venture brings ETFs to the alternative realm via a distinct replication methodology seeking to offer exposure to the return profiles of a number of hedge fund indices. Is this the wave of the future? Adam is here to shed light on this growing segment of ETFs.

Q1: Why does the market need another ETF product? How does your replication methodology differ from Harry Kat or Andrew Lo or other replication products?

We are acutely aware of the proliferation of ETFs and only plan to bring to market those ETFs that meet investor needs that are currently not being met by existing products. QAI is a great example of this focus as it is designed to fill a gap in the existing ETF marketplace by providing investors with hedge fund-like exposure in a liquid, transparent, cost effective vehicle.

IndexIQ uses a factor-based model, while the replication methodology put forth by Harry Kat is more of a “returns distribution matching” approach. What this means is that the process employed by Professor Kat and others is designed to generate a set of returns that, over an extended period of time, will have similar statistical properties to a target return series. The approach employed by Professor Lo, by contrast, is factor based and is more similar to the approach employed by IndexIQ, yet important differences remain. Importantly, IndexIQ attempts to provide hedge fund-like exposure at the strategy level (e.g. Emerging Markets, Long/Short, etc.) while the Lo approach focuses on replicating individual hedge funds. The IndexIQ approach further allows for an allocation process that can systematically over and under-weight strategies at different times. This allocation process has been an important contributor to the strong results seen thus far.

Meanwhile, back to the ETF industry. The mutual fund industry still dwarfs the ETF industry and we believe, given all of the structural benefits of ETFs, we are still in the early days of ETF development.

Q2: The benefit of hedge funds is that the return profile does not correlate to the market. Do IndexIQ products also deliver the benefits of non-correlation? Do you have enough data on the correlation relationships?

The correlation of IndexIQ hedge fund replication products to the broad equity market (as represented by the S&P 500) is similar to the correlation of aggregate hedge fund returns to the broad equity market.

The correlation between hedge fund indexes and the broad market depends on the hedge fund index in question, and may fluctuate over time along with hedge fund performance.

Our ETFs offer similar risk return characteristics without the structural impediments of hedge funds, which are characterized by illiquidity, high fees and a lack of transparency, and often lack of access to the best managers. In fact, the performance of (and behavior of some) hedge funds in 2008 is effectively our product positioning – we offer low-correlation return profile without gating, long lock-ups and individual manager risk.

Q3: Please fill in the blanks and explain your answer. “If I were _______, I would be worried about the launch of replication ETFs.” What markets are you targeting with the suite of ETFs?

There is a broad group of investors that do not have access to hedge funds at all because of the accredited investor rules. Having an exchange traded alternative product available to these investors is a way for them to access the positive merits of hedge fund investing.

Further, we certainly believe that there are many talented hedge fund managers in the world. However, for investors whose hedge fund managers have not been able to deliver the types of returns that their clients had hoped for,  who saddle them with high fees, a lack of transparency into the process and positions, and limited liquidity, hedge fund replication products should be viewed as a viable alternative.

Interestingly, we are seeing interest coming from hedge fund-of-funds who are using our products in a core-satellite approach or as efficient alternative beta where the core portion of the portfolio uses liquid, alternative beta products and the satellite portion employs individual hedge fund managers. This allows for greater liquidity in their portfolios and a lower overall cost structure.  Fund-of-funds are also using our ETFs to equitize their cash positions during rebalances.

In addition, we have had significant institutional interest, most recently from the City of New Haven, which desired to gain hedge fund-like exposure without the structural and headline risk issues of direct investment.

Q4: What are you hearing from clients and prospects? Is there sufficient knowledge of factor-based replication to understand these products?

The adoption of hedge fund replication, like any other new approach, can take some time. As hedge fund replication products have generated attractive risk and return profiles, investors are becoming more comfortable with them. We are starting to see an increase in the awareness and adoption of investors as our products are performing as expected.

Investors want to see the products working with real money. They want to understand the methodology and most importantly want to see how to use the ETFs in their portfolio. We provide a more consultative approach and provide different sample portfolio allocations to show what dialing up or dialing down will do to expected risk and return.

Q5: The buzzwords among alternative investors this year have been transparency and liquidity and the best expression of those trends have been the growth of managed accounts. Do you see these ETF products leap-frogging managed accounts on the liquidity spectrum or are you targeting different investors?

Both product wrappers have their advantages. Importantly, both solve many of the frustrations associated with direct hedge fund investing. However, there are important differences. ETFs offer intraday liquidity while managed accounts will generally be end of day. However, managed accounts can potentially be customized to meet specific client objectives (i.e. targeting higher returns, lower risk or tax management) while ETFs do not offer customization.

Q6: ETFs from Rydex, Direxion and ProShares have attracted the scrutiny of regulators for the sales practices of the leveraged products? Do you see similar risk for IndexIQ products?

IndexIQ products do not use leveraged ETFs to implement our strategies, nor do our ETFs employ leverage of any sort. In fact our strategies are typically low volatility strategies designed for portfolio diversification. We are confident that our portfolio management and sales processes are consistent with both the intent of the underlying strategies and the regulatory requirements of the products.

However, certainly our sales model is reliant on a heavy dose of education. Investors are becoming much more sophisticated on the use of ETFs in a portfolio as evidenced by the total AUM breaking through $1 trillion. We are generally targeting sophisticated investors and not the retail audience at this time and have not run into confusion with leveraged ETFs.

Q7: The most recent product is a merger-arb ETF. Talk through the methodology of putting together the ETF products? Has there been sufficient data to determine the durability of returns?

The research underlying all of our ETFs begins with an initial discussion of the investment thesis and the merits of developing a particular strategy. Once we determine that the ETF can potentially satisfy a missing exposure for investors, we consult with our academic advisory board to fully vet the idea and to begin to compile academic support for the product. With our merger-arb ETF, we underwent a rigorous research process whereby we compiled data on 10 years of merger and acquisition transactions to determine the characteristics of deals that consistently provide the most significant ROI. From that we created an index rule-set used to create portfolios that would have existed at certain points in time with the data that was available at that time. We then test our hypothesis that the portfolio construction process we have proposed would indeed have performed in line with our a priori expectations. All of our research generally extends back at least 10 years and can go back even further if there is reliable data available. This helps us to check the return pattern across different market cycles and economic environments.

The merger-arb index has been publishing returns dating from 2007 – which provides a good starting point to assess the durability of returns. The ETF has performed as expected – it provides the exposure, importantly, in an ETF wrapper, and offers significant tax benefits.  As a result we have seen considerable interest.

Hedge funds: you either love ‘em or hate ‘em, right?

Well, it appears that investors and commentators may actually love them and hate them at the same time.  As Wikipedia defines a “love-hate relationship:”

“…a personal relationship involving simultaneous or alternating emotions of love and enmity. This relationship does not have to be of a romantic nature, and may be instead of a sibling one. It may occur when people have completely lost the intimacy within a loving relationship, yet still retain some passion for, or perhaps some commitment to, each other.”

It seems that every January, there is a proliferation of media stories about how – despite their apparent disdain for hedge funds -  investors show a commitment to hedge funds by clamoring to mimic them through either a) hedge fund replication products or b) “hedged” mutual funds. More…

The infinite monkey theorem states that a monkey hitting keys at random on a typewriter keyboard for an infinite amount of time will eventually bang out some sort of recognizable text, such as the complete works of William Shakespeare.

Along the same lines, one might argue that Exchange-Traded Funds, or ETFs, are in alternatives’ form at least a version of the monkey-at-typewriter theorem, by virtue that a synthetic composition of securities combined into something that is purportedly a hedge fund can mimic, if not the best, but the same strategy and returns as a hedge fund manager — eventually.

All this monkey business theory stems from Rye Brook, New York-based IndexIQ’s release of the IQ ARB Merger Arbitrage ETF (ticker: MNA), which began trading this past Tuesday.

How it works: the ETF relies on a fixed rule book – the main requirement being that an acquirer must have offered a premium to a target company’s market price: More…

Ah, the good old days – when the hedge fund “secret sauce” was revealed and suppliers set about developing the products that would bring it to investors the world over under the moniker “hedge fund cloning”.  But as Swiss researchers Erik Wallerstein, Nils Tuchschmid and Sassan Zakerc note in a recent paper called “How do hedge fund clones manage the real world?”:

“Some years ago hedge fund replication was a much discussed topic on the hedge fund horizon. A credit crunch and some hedge fund Ponzi schemes later, the attention has turned elsewhere.  2008 performance of broad hedge fund indices where dismal at best. This did not bode well for selling pitches to persuade investors to turn to funds which replicate this performance.”

However, the trio goes on to argue that the $2 billion hedge fund replication business is far from dead.  Hedge fund replicas, they say, “…have several unique and interesting features, many which where attractive during the crises of 2008.”

They analyze the recent performance of 21 hedge fund clones from 17 companies covering the full spectrum of replication techniques from factor replication to distributional replication to mechanical replication.  (see the “Alternative Beta and Hedge Fund Replication” category at the right side of this page for extensive coverage of these topics).

Here’s how the 21 fund stack up from March 2008 to May 2009 (chart based on data in paper)… More…

With hedge fund performance starting to look up, a reader recently suggested we check up on the trials and tribulations of “hedge fund replicators” – those who aim to clone the returns of hedge funds via passive exposure to highly liquid and ubiquitous investments.  The most well understood method of doing is to use a factor model based on a trailing regression of hedge fund industry returns.  One of the most prominent players in this space is probably Merrill Lynch, purveyors of the “Merrill Lynch Factor Model” (factor model website).

The firm describes the index this way in its marketing sheet: More…

In just about every action movie and TV show these days there is at least one scene where the hero asks one of his or her techies to “sharpen” a satellite image.  Suddenly, what looked like a fuzzy bunch of pixelated squares takes on the form of someone’s face, a car, or some kind of mobile rocket launcher.   We’re not graphic imaging specialists.  But to us, it looks kind of outlandish that someone could take a very small amount of information (a few pixels) and divine the underlying image in fantastic detail.

But in a way, that’s exactly what Daniel Li & Michael Markov (of quantitative investment software vendor Markov Processes) and Russ Wermers of the University of Maryland have done in a paper released last month called “Monitoring Daily Hedge Fund Performance When Only Monthly Data is Available.”  Their trick is to leverage another kind of technology: hedge fund replication.

As we have reported extensively, “linear factor replication” aims to predict the performance of hedge funds based on a multiple regression of their historical returns on a number of variables such as equities, Fama/French factors, and several more “exotic” risk factors. More…

Passive investment in hedge funds has always been somewhat of an oxymoron.  Hedge funds, after all, aim to deliver active management (alpha).  And since alpha is a zero sum game, a passive investment in hedge funds should deliver a zero return.  Nonetheless, this axiom has always been challenged by proponents of various products designed to deliver aggregate “hedge fund returns”.

First there was the passive fund of funds; then came the investable hedge fund index; and finally there was hedge fund replication.  In essence, all of these products delivered similar value propositions: diversification, transparency, and liquidity.  (Despite the tendency for these providers to compete on returns, out-performance was never officially the goal of these “passive” products).

Hedge fund replication seemed to be the story of the year in 2008.  But in the post-Madoff environment, the pendulum may be swinging back in the other direction.  The investable hedge fund index – derided by proponents of hedge fund replication as being expensive and opaque since it invests in hedge funds themselves - is making a comeback. More…

Looks who’s making a return trip to the news after being largely tossed away by the media last year.  It’s alternative beta and 130/30.  As regular readers will recall, these hedge fund relatives seems to have died off last fall.  But this week, several firms announced new funds aimed at resurrecting interest in “hedge fund replication” and “short-extension” strategies.  And who knows, the time may now be right for these quasi-hedge fund instruments.

Clones or Zombies Back from the Dead

Hedge Funds Review reported today that Invesco, the mutual fund giant, launched an alternative beta strategy called “Premia Plus” (not to be confused with Premium Plus, the perfectly flaky cracker from Kraft).  Without calling itself a “hedge fund” (now a four letter word in the post-12/11 environment), the company borrows heavily from the hedge fund lexicon.  According to Hedge Funds Review, Invesco says it has developed a proprietary risk management strategy that “could generate equity-like returns with bond-like risk.”

The magazine also reports that Invesco is emphasizing many of the now de rigueur qualities of liquidity, low price and “transparency”.  (Although we wonder how useful “transparency” really is when the product still uses a “proprietary risk management and rebalancing technique”).

Not content to let Premia Plus steal the headlines, Barclays Capital just launched the “Barclays Alternatives Replication” Index last week.  The index comes in long and short versions called LBAR and SBAR (much like Innocap’s products and T-Rex offered by Socgen).  Barclays says that LBAR tracked the HFRI better than “four main competing hedge fund indexes” last year.  This statement is a refreshing change in a field where companies often seem to compete on the basis of performance, not tracking error.

Why the reincarnated interest in hedge fund replication?  According to Reuters: More…