An ETF takes on hedge funds

NEW YORK (Fortune) -- After dozens of blow-ups and the stink of the Madoff mess, a sane investor might think any investment with "hedge fund" in its name might as well be called "run screaming in the other direction."

But firms keep coming up with new hedge-fund products for retail investors. They promise performance independent of the plummeting broader market without the risk that a manager is an over-leveraged Ponzi-in-waiting.

Now for the first time, an exchange-traded fund joins the parade. Last week New York-based IndexIQ launched the IQ Hedge Multi-Strategy Tracker ETF (QAI). Its goal is to passively replicate the overall performance of hedge funds. As John Bogle did with stocks through Vanguard's index mutual funds, IndexIQ hopes to do with the hedges.

In theory, this might be a good idea. Historically hedge-fund indexes perform better than the S&P 500 index (SPX) and with less volatility. Since it started 1994, the Credit Suisse/Tremont Hedge Fund index has averaged an 8.7% annual return, versus 5.0% for the S&P 500. Last year, the index fell 18.7%, compared with a 39.3% drop for the S&P 500.

But IndexIQ isn't just a pure basket of all hedge funds. The firm's financial engineers study the performance of the Hedge Fund Research index and the Credit Suisse/Tremont Hedge Fund index, which pull real return data from thousands of hedge funds.

They then model those indexes' returns, volatility and other more statically complex characteristics. Based on that model, they pick a basket of other ETFs that together have a very similar statistical profile. Thus, in theory, investors get very similar returns to actually investing in thousands of hedge funds.

The returns produced by IndexIQ in the lab, however, aren't exactly like those of the indexes. The ETF would have fallen 8% in 2008, which sounds pretty good compared with the 18.7% drop for the Credit Suisse/Tremont Hedge Fund index, but it's not an exact science.

IndexIQ's chief executive Adam Patti attributes the discrepancy to actual hedge funds getting stuck in liquidity traps last year, where managers were forced to sell positions at below-market prices because of investor redemptions. Without that factor, he warns, "Don't expect us to outperform going forward." (Full disclosure: Patti used to work at Fortune on the business side.)

Many experts say there are limits on how closely replication can match hedge-fund performance. Oliver Schupp, head of beta strategies for Credit Suisse, says that some hedge-funds returns are ripe to be mimicked in a passive instrument. "The more quantitative strategies try to capture differentials of stocks or sectors," he says. "Those kind of strategies you'll find easier to model."

By contrast, the returns of hedge fund strategies that thrive on illiquidity and inefficiency, like distressed investing, can't be imitated. "You won't be able to model that same liquidity premium," he says.

One skeptic of IndexIQ's approach doubts that it will even be able to capture non-correlation to the market. "Everything hedge-fund specific is diversified away," says Harry Kat, professor of risk management at the Cass Business School in London. "All that is left is equity and credit risk." Kat says his own research suggests that most replication strategies are about 80% correlated to the broader market.

Patti predicts that the ETF will match the performance of the market only between 40% and 60% of the time by focusing on ETFs that only use relative-value trades, meaning they try to exploit inefficiencies in prices rather than betting on any market going up or down.

But that strategy could run into the limitations of ETFs themselves. "Most of the best inefficiencies in the market, by definition, are the smallest inefficiencies," says Eric Newman, portfolio manager of TFS Capital, which runs a mutual fund focused on non-correlated investments. "A broad ETF that is structured to have billions in capacity can't really get at those."

The IndexIQ ETF's biggest holdings are the Barclays Aggregate Bond Fund (AGG) at about 22% of the portfolio, Barclays 1-3 Year Treasury Bond Fund (SHY) at 20%, and the MSCI Emerging Markets Index Fund (EEM) at 12%. Overall it's about two-thirds bonds with the rest a mix of currencies, real estate and shares of non-U.S. companies.

The other major benefits of the ETF, says Patti, are cost and liquidity. With an expense ratio of 0.75%, it's much cheaper than any actual hedge fund. And in ETF form, it can easily be sold at any time, whereas hedge funds often lock up investor cash for years.

Morningstar analyst Paul Justice recommends investors allocate, at most, 10% of their portfolios to this ETF or any hedge-fund-like instrument. That's about what large institutions typically allocate to alternative assets.

"It should be used in moderation," he says. "You should be able to at least grasp the concept, or you're playing with fire."