The capital markets abhor a vacuum and as exchange-traded funds grow more popular, their uses keep multiplying to fill every space that their creators and investors can identify.

In the world of registered investment advisors, many RIAs are now working with ETF firms to create custom-made funds to suit their clients’ portfolios.

Sometimes the ETFs that are created are relatively simple “pure play” creations focused on a single market niche. But other times, the quants on IndexIQ’s academic board create a more complex set of proprietary investments capable of making hedge fund managers turn red with rage. How? By using a rules-based philosophy that combines the beta benefits of traditional index investing with the high alpha returns sought by active managers.

In short, the firm designs cheap, liquid ETFs suitable for portfolios of any size that replicate the returns of expensive, locked-up hedge funds.

When an RIA recently came to Kevin Malone, president of Greenrock Research, which offers asset allocation strategies, Malone recommended an IndexIQ portfolio combining three hedge fund replication ETFs, a mutual fund and an absolute-return, inflation-hedging ETF:

“What happened was, the RIA called us and said, ‘George Smith has $50 million, and these are his goals. What should the portfolio look like?’ We worked collaboratively to come up with the asset allocation strategy,” Malone recalled. “When we got to alternatives, we said, ‘This should be half of your alternative allocation.’ Then two months later, the same client called and said, ‘We’ve got this $100,000 portfolio. We used the same solution.’ That’s the brilliance of it—it’s not just the solution for a small client. It’s the solution because it has intellectual integrity. This is a great idea for anybody of any size.”

Malone pointed to Roger Ibbotson and Peng Chen’s 2011 study, “The ABCs of Hedge Funds: Alphas, Betas, and Costs,” which concludes that hedge funds between 1995 and 2009 have resulted in about 10% to 15% of alpha return, 60% to 65% of beta return and 20% to 25% in fees.

“Why would you pay hedge fund fees where you’re only getting alpha return that’s 10% to 15%? We think we have fee structures that are about a third or a quarter of what hedge funds are by using ETFs, and we’re probably going to get similar returns and have complete liquidity. That’s what we use IndexIQ for,” Malone said.

How to hedge with ETFs

The five IndexIQ funds achieve a similar return pattern to a hedge fund over approximately 18 months, Malone said.

“We studied those five funds and came to the conclusion that over time, those five funds should replicate hedge funds,” he said. “The core of one’s hedge fund strategy, we believe, should be a diversified group of funds similar to the diversified group of hedge funds you would get in an alternative investment fund of funds.”

The key, Malone said, is that ETFs can be invested in the very same asset classes that hedge funds invest in. “You can do anything in ETFs that you can do in hedge funds. We think hedge fund replication is the core of one’s alternative space,” he said.