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By Mallory Horejs, CFA | 09-22-2011 05:06 PM

Don't Pay Alpha Fees for Beta Performance

Hedge fund-replicating ETFs and mutual funds can provide investors with similar return characteristics at a much lower cost, says Index IQ's Adam Patti.

Mallory Horejs: Hello. My name is Mallory Horejs, and I'm here at the 2011, Morningstar ETF Invest conference. I have with me Adam Patti, the CEO and founder of Index IQ, a firm that specializes in innovative index-based investment strategies.

Adam, thanks so much for joining us today.

Adam Patti: Thanks for having me.

Horejs: So, Index IQ is particularly well-known in the liquid alternative space for its hedge fund-replication products. I was hoping you could explain to our viewers how a strategy like this works and how it's differs from actually investing in a hedge fund?

Patti: Sure. These are very exciting products, and certainly in today's market volatility underscores the need for them in a well-diversified portfolio. What hedge fund replication is, as succinctly I can be, there are 10,000 hedge funds today. There are as many hedge funds out there as mutual funds. As we know, 85% or so of actively managed mutual fund managers underperform their benchmarks every year. So, this goes to show that the same should be going on in the hedge market, which it is. Not everyone is getting into the best hedge funds. It's just mathematically impossible. Somebody is getting into the ones that underperform.

So, what the academics proved in the '90s is that when you look at hedge fund performance you can identify their asset class exposures using a very simple style analysis. We don't care what an individual hedge fund manager necessarily is buying or selling. We care about what the broad group of hedge fund managers are buying or selling. So, if you can identify their asset-class exposures, you can replicate their performance characteristics using liquid proxies for those asset-class exposures. For us we use ETFs as the proxies for them and what we did in 2007 is, we launched these series of hedge fund-replication indexes that mirrored the performance characteristics of six of the largest hedge fund strategies, and those have been alive for almost five years. We use those as a building blocks for our various products like QAI, or MCRO or our mutual fund, IQHIX.

Horejs: OK. That's helpful for them. If you look at how the strategies have held up this year, what's something that you'd like to note?

Patti: Sure. I mean these products are designed to give you the risk/return characteristics of hedge fund investing without investing in hedge funds, so they are transparent, liquid, low-cost and tax-efficient. Today (Sept. 22) is a great example. I mean today the market was down almost 4%. QAI was down 0.6%, with about a fourth of the volatility of the S&P 500. CPI, which is another product that uses a very similar strategy, was actually up today. In August when the market was down 5%-6% QAI was down 0.5%, and CPI was up 1.5%. These are the tickers, CPI and QAI.

So, these products are now designed to shoot the lights out when the equity markets are going straight up. Investors have other asset classes to be in for that. What we're designed to do is, how do you lose less, because there are two ways to outperform their market: outperform on the upside or you can outperform on the downside, and if you're down 40% or 30% in the year, it's a lot harder for an equity manager to make that up for investors.

Horejs: We've definitely seen a strong demand for those types of products this year. Seeing as this is the ETF conference, I want to talk a bit about the three ETFs you offer, the IQ Hedge Multi-Strategy Tracker, ticker QAI; the IQ Hedge Macro Tracker, ticker MCRO; and IQ Hedge Merger Arbitrage, ticker MNA. So, how does that compare with your mutual fund product, the IQ Alpha Hedge Strategy fund, ticker IQHIX?

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