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Indexing Strategically

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What if you could index the investment strategies of hedge fund managers? And what if you could do it with lower fees, better tax efficiency and greater transparency? One company that believes it has found a way to accomplish this feat is IndexIQ.

The New York City-based asset manager was founded in 2006 on the premise that indexing can be successfully applied to high quality institutional investment strategies.

IndexIQ has developed its own lineup of hedge fund indices that incorporate long/short, market neutral, fixed income arbitrage, event driven and global macro strategies. The company believes that financial advisors can help their clients to reduce risk and increase returns by adding these types of strategy ETFs to the overall asset mix.

At the end of May, IndexIQ managed around $488 million in spread across nine ETFs.

Research magazine interviewed Adam Patti, CEO of IndexIQ about the state of the ETF investing.

How has indexing evolved from its origins to where it’s at today?

Actively managed “alpha” is very difficult to find and even more inconsistent, largely due to the sheer number of active managers in the market who compete away the finite number of market inefficiencies which are the basis of “alpha.” It was a natural evolution for indexing to move beyond the traditional passive indexes, which were designed as benchmarks, not necessarily as optimal investment strategies, to more sophisticated methodologies that were specifically designed to provide investors access to more unique exposures and more sophisticated investment strategies.

Today, index investors can access many investment strategies that were once the exclusive domain of active managers. These indexes have proven that in fact much of the value driven by active managers has actually been in their investment process which can be boiled down to a rules-based methodology. The difference of course is that when packaged as an index, the products can have lower fees, full transparency and, if designed properly, greater consistency in terms of pattern of performance.

Commodities have gotten clobbered this year, but higher inflation due to currency debasement is always a threat. What are some ways to guard against this?

Investors need to be careful how they express their commodity exposure. For one, what kind of exposure are you looking for? Some of the “diversified” commodity ETFs on the market are little more than energy funds masquerading as diversified commodity funds.

Another thing to look at is whether you want your commodity exposure coming through derivatives or through equities. Both have their pluses and minuses. However, most investors don’t understand how the pattern of performance of derivative based strategies are impacted by contango and backwardation. Nor do they typically expect the K1s that are often tied to the derivative-based strategies. Also, investors need to understand that equity-based commodity strategies typically don’t provide the diversification benefits they are looking for given that commodity producer equities typically have higher correlation to the equity markets then the derivative-based products.

IndexIQ launched the IQ Global Resources ETF (GRES) in 2009 as the broadest natural resources ETF in the marketplace. It includes all of the major commodity sectors that the competing products include; however it also includes timber, water and coal as standalone sector exposures.

GRES is never overly concentrated in any one of its eight commodity sectors because GRES rotates among those sectors monthly using momentum and valuation factors to “buy low and sell high,” while capping any sector’s exposure to 22.5% of the portfolio. And while GRES is an equity-based strategy, it includes 20% short exposure to the global equity markets to pull out that equity beta and reduce volatility. The result is a product that offers the diversification benefits of a derivative-based commodity fund with among the highest returns and lowest volatility in its competitive set in each year since inception. This year alone we are ahead of the Dow Jones UBS Commodity Index benchmark by 4-5%.

The IQ Hedge Multi-Strategy Tracker ETF (QAI) and the IQ Hedge Macro Tracker (MCRO) just celebrated their 3-yearanniversaries and these particular ETFs were a breakthrough offering on many fronts. Tell us more.

Hedge funds have been a core alternative holding for institutional investors for 25 years. They diversify a portfolio by providing low volatility, low correlation downside protection in rough markets, yet retaining upside potential when the markets turn positive. Most investors haven’t had access to this important exposure, so we at IndexIQ focused on providing it in a low cost, transparent, tax efficient wrapper.

QAI and MCRO provide the same pattern of performance as institutionally owned fund of hedge funds, however, with all of the benefits of an index-based ETF structure. Think of QAI as the S&P 500 of the hedge fund marketplace.

Back in 2007, IndexIQ launched the world’s first family of hedge fund replication indexes, covering six of the most important hedge fund strategies. These are long/short, market neutral, fixed income arbitrage, global macro, emerging markets and event driven. Each of these indexes has been calculating since March 2007 and form the basis of our investable products. QAI is a combination of the six strategies, so in essence is a synthetic fund of hedge funds and often investors use it as a core holding in their alternatives sleeve of their asset allocation. MCRO is our Global Macro play which is more equity directional and a complement to equity exposure, and we have a mutual fund, IQHIX, that is similar to QAI but in a mutual fund wrapper.

What are the advantages of the IndexIQ Hedge Fund Replication ETFs overtraditional hedge funds?

Hedge funds provide very important diversification benefits for investor portfolios. Our hedge fund replication ETFs, like QAI, MCRO and MNA (Merger Arbitrage), have proven to offer the same benefit.

However hedge funds suffer from a significant number of structural impediments beyond the fact that most investors can’t access them.

Hedge funds are notoriously expensive, charging on average 2% management fee and 20% of the investment gains on an annual basis. Funds of hedge funds go one step further and typically charge an additional 1% management fee and 10% of investment gains on top of that. IndexIQ’s hedge fund ETFs charge [0.75%] management fees.

Hedge funds are very tax inefficient. They are typically limited partnership structures, thus they pass through capital gains on portfolio turnover and issue K1s to their investors. IndexIQ’s hedge fund ETFs, like QAI and MCRO, have never passed through capital gains on portfolio turnover nor do they issue K1s.

Hedge funds are opaque in regard to their portfolio holdings and investment strategies. They typically do not provide investors much information in regard to what they hold or their actual investment strategies. IndexIQ hedge fund ETFs are 100% transparent … in terms of the index methodologies which are posted on our website and update portfolio holdings on the website daily.

Hedge fund investors must fear “headline risk.” We have all heard the horror stories of once storied hedge funds suddenly “blowing up” due to errors or poorly designed trades. With IndexIQ hedge fund ETFs investors need not fear this risk of blow-up. Each of our ETFs invests in liquid securities, which are fully divulged on a daily basis.

Despite [these] structural issues, we feel that hedge funds could be valuable additions to a diversified portfolio. However, we strongly believe that our liquid hedge fund ETFs should form the core of these investor allocations and traditional hedge funds should be thought of as the “alpha-seeking” satellites. Our hedge fund ETFs have stood the test of time and have delivered hedge fund return patterns without hedge fund issues.

Ever since the May 2010 “Flash Crash” there [have] been structural concernsabout ETFs. Do you think these concerns are warranted?

No, ETFs are often used as a scapegoat for market structure concerns. It’s been well documented at this point that ETFs were not remotely the cause of the Flash Crash but rather were the victims of the crash just like many other equity securities. Other poorly thought out accusations have been made against ETFs since that time, which after the initial uproar have been found to be incorrect. The unfortunate thing is that the media often picks up on the initial reports, which while incorrect, often serve to misinform investors. It then takes quite a bit of effort to re-educate investors with the correct information.

Why should financial advisors be interested in hedge fund replicationstrategies?

All investors need to be hedged. Institutional investors have had significant allocations to hedge fund strategies for 25 years. It’s only recently that investors who aren’t large institutions or the ultra high net worth can access similar strategies to diversify their portfolios.

You earn more by losing less. Many investors are often blinded by the huge run-ups of some hot securities; however they need to understand that wealth is generated by protecting the downside. One large drawdown on your portfolio could take years to recover from unless you plan for it and protect against it as best you can. Hedge fund replication strategies provide investors the downside protection you need, and the upside potential you expect.

What percentage of a client’s portfolio do you think advisors should be dedicating to alternative strategies?

This really depends on an individual client’s goals and asset allocation. If you look into the institutional space, you see those investors typically have 30-40% invested in alternatives which include hedge funds, commodities, real estate, private equity and other asset classes. Many retail investors are not quite yet where the institutions are but are slowly migrating there. We spend a lot of time helping advisors analyze their clients’ portfolios and proposing changes that could improve their risk/return profile. The most frequent asset allocations we see include at least 20-30% of a portfolio in alternatives.


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