A Look Inside The Hedge Fund ETF

The new IndexIQ Hedge Fund ETF (NYSE Arca: QAI) is one of the most interesting … and controversial … ETFs to launch in a while.

The fund, which aims to synthetically replicate the performance of hedge fund strategies, launched yesterday on NYSE Arca. Judging by early trading volume, the new fund is going to be a hit: QAI looks like it will trade more than 100,000 shares today, an impressive performance for just its second day on the market.

The idea of providing access to hedge fund-like returns through an ETF is hugely attractive. The best investors in the world—endowments like Harvard and Yale—hold enormous investments in hedge funds for a reason: They deliver returns with low correlations to the broader market. If QAI can make those returns available to all investors in a low-cost wrapper, it’ll be big news.

As I said yesterday on CNBC, however, the proof will be in the pudding: Can QAI actually deliver on its promises?

It’s important to understand that this ETF doesn’t actually invest in hedge funds; rather, it uses factor-based analysis to determine the performance characteristics of hedge funds in general, and then builds a portfolio (using other ETFs) that it thinks will replicate that performance.

Over the past few days, a lot of people have told me that this idea sounds crazy. I disagree. Too many people have a near-mythical conception of hedge funds; they think they are run by high-paid geniuses who make either spectacular or spectacularly bad investments. The truth is more mundane: While some hedge funds ARE run by geniuses, most are run by normal guys who use pretty standard strategies to generate a certain kind of return. They do a reasonable job, and are paid absurdly well to do it.

The idea of synthetically replicating that performance at lower costs is well-established both in academia and the real world. Both Goldman Sachs, and IndexIQ itself, for example, have been running synthetic hedge fund mutual funds since last summer. Generally speaking, they’ve done pretty well: The Goldman Sachs fund is down about 15% since July 2008, while the IndexIQ fund is down about 12%; that compares to the S&P; 500, which is down about 38%. That’s a good relative performance. Most hedge funds are down over that span too, in line with the synthetic products.

The question now is whether these funds will be able to perform well as the market recovers. Although both funds have well-documented methodologies, they are nonetheless largely black box strategies; the concept behind the funds make sense, but you have to have faith that the quant-engine driving them is going to work.

One advantage of the new ETF is that you can watch the holdings on a daily basis and see for yourself if they make sense. As of yesterday’s close, here’s what QAI was holding:

If you drill down, the portfolio is fairly simple. The fund’s positions include:

• 72.79% fixed income, including 32.73% in broad-based bond indexes; 27.71% in short-term Treasuries; 10.54% in junk bonds; and 1.81% in TIPS
• • 13.33% in emerging market stocks, the only long equity position in the portfolio
  • 9.47% in commodities and currencies
  • 4.41% in various inverse funds

That’s a fairly defensive portfolio. The question is, how will this portfolio perform if the market recovers? How will it adapt and change over time?

It’s worth watching.