The first exchange-traded fund designed to replicate hedge fund strategies is set to launch on Wednesday.

After receiving a final green light from the Securities and Exchange Commission at midday, the IQ Hedge Multi-Strategy Tracker ETF (NYSE: QAI) should start trading by day's end, according to IndexIQ Advisors LLC. 

If it's able to truly mimic popular fund-of-hedge funds, the new ETF could provide the first real challenge to a fee structure critics characterize as highly exorbitant.  

Most actively managed hedge funds charge annual expenses of 2% and tack on another 20% in performance fees. But QAI, which will follow a benchmark launched by IndexIQ in March 2007, comes with a single fee structure. That's an expense ratio of 0.75%, which will be assessed annually. 

Last summer, IndexIQ came out with an index-based mutual fund based solely on replicating hedge fund strategies. The IQ Alpha Hedge Strategy Fund has a net expense ratio of 1.64% and is sold directly through the firm. (See related story here.)

Its main competitors focus on one or two types of hedging techniques and rely on calls made by veteran mutual fund managers such as John Calamos and John Hussman. The most direct rival is probably the Goldman Sachs Absolute Return Tracker Fund (GARTX).

The Goldman Sachs fund, however, uses a differently methodology that focuses on a more passive approach and controlling volatility. The IndexIQ process implements optimization strategies to overweight and underweight different areas of the hedge funds market, essentially trying to add alpha. (See related article here.) 

A Changing Landscape

With the emergence of a fund-of-hedge funds ETF, QAI no doubt will lower the price bar even more for hedging strategies. (It's interesting to note that Vanguard has come out with a market-neutral mutual fund, but it's aimed at institutional investors and carries an even higher expense ratio than the more-diversified IQ funds.)

"What we're bringing to investors is a transparent and disciplined way to take advantage of the diversification benefits of hedging strategies—without paying an arm and a leg," said Adam Patti, chief executive of the Rye Brook, N.Y.-based index and fund provider.  

The benchmark for QAI resembles a fund-of-funds portfolio since it includes six different types of hedge fund strategies. The idea is to capture the entire hedging universe rather than singling out one or two strategies. The ETF includes hedging strategies covering long-short; global macro; market neutral; event driven; fixed-income arbitrage and emerging markets.

QAI's index will be rebalanced monthly. Entering the launch, its benchmark was weighted as follows: emerging markets (2.83%); long-short (-16.67%); global macro (13.83%); and 33.33% each in event driven, fixed-income arbitrage and market neutral.

But can an index-based ETF replicate the performances of thousands of active hedge fund managers?

IndexIQ says they've got a few important factors weighing in their favor. One of those is the sheer size of the hedge fund industry. In 1984, for example, some 84 such funds were around. Now, that total has increased to more than 9,200. And that's after an estimated 1,400 hedge funds have closed in the past six months.

"The characteristics of hedge fund investing have changed. Now that there are almost as many hedge funds in the market as mutual funds, we're seeing a different type of performance profile of that universe," said Patti.

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