Replicate Hedge Funds With ETFs

“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.

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.