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Investors Look To Hedge Fund 'Clones' In ETFs

Tuesday, 28 Jun 2011 | 2:38 PM ET

In the wake of unprecedented turmoil for the hedge fund industry, stemming from legal probes, lackluster returns and looming anti-growth regulations, a new crop of so-called "hedge fund replication" investments are gaining popularity in the form of easy-to-buy-and-sell exchange traded funds (known as ETFs).

“We are trying to democratize alternatives,” says Adam Patti, CEO of IndexIQ, a hedge fund replication ETF developer based in Rye Brook, New York.

The hedge fund replication concept was born out of the idea to create an investable “clone” of a hedge fund portfolio that mimics the latter's volatility and performance characteristics.

Patti’s IndexIQ has launched nearly a half-dozen hedge fund replication ETFs since it began offering the investments back in March 2009, and its flagship product, the IQ Hedge Multi Strategy ETF, has seen its assets under management grow from a modest $5 million to a respectable $140 million since that time.

Patti’s other hedge fund replication ETFs, while still a fractionally minor piece of the trillion-dollar ETF market, have all seen similarly quick-paced growth.

As Patti explains, these investments have gained some initial popularity because they offer “the diversification benefits of investing in hedge funds without the structural impediments of investing in hedge funds themselves” — structural impediments that are well-known for investors.

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Hedge funds often limit their investor base to high-net worth clients and often require starting investments of between $250,000 and $500,000. Then there are the fees, which typically run about 2 percent of the total portfolio size and 20 percent of any trading profits. On top of that, there are often lockup requirements that limit when investors can withdraw funds.

“We hated, almost from day one, the alternative investment [hedge] fund of funds because of the fees were huge...and there were lockups,” says Kevin Malone, CEO of Greenrock Research, a Chicago-based research firm that recommends hedge fund replication investments, like IndexIQ’s QAI, to its clients because of their low fee structure.

As of the first quarter of this year Bank of America, UBS and Credit Suisse all held small positions in Patti’s ETFs, according to SEC data compiled by Factset.

But these investments are not without their detractors and potential downsides.

Some hedge fund replication critics point out that much of the allure from investing in a hedge fund is the promise that it will provide outsized returns, but broadly speaking, hedge funds have lagged broader markets since the financial crisis.

The S&P 500 has rallied about 90 percent since March 2009, while hedge funds, as tracked by Chicago-based Hedge Fund Research, have returned only a fraction of that. Critics contend that investing in a product designed to mimic those results would provide limited upside for a portfolio.

“For smaller investors, they’re okay if you want to get exposure to some hedge fund strategy that you think is going to outperform over time,” says Donald Steinbrugge, a managing member of hedge fund consultant Agecroft Partners. “But for sophisticated investors, I don’t think they’re a good choice.”

Also, hedge fund portfolio managers are notorious for the speed and frequency with which they change their holdings in an attempt to time the market, and the hedge fund replication ETFs engineer their holdings based on factors that make it difficult to match the portfolio composition or performance of their hedge fund counterparts.

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