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.

When they were small and nimble, hedge fund managers were much better able to exploit market inefficiencies, says Tony Davidow, IndexIQ's executive vice president. "What we've seen in the past 18 months were bigger hedge funds finding it difficult to unwind their strategies as market conditions dramatically changed," he said. "And that has led to very poor performance."

He adds that hedge fund managers are likely to keep finding it increasingly difficult to deliver greater returns than the market, which is called excess alpha in the industry.

As a result, Davidow believes that investors "are paying exorbitant fees in return for unremarkable results."

He points to a recent study by Ken French, a Dartmouth professor, showing that the average hedge fund was charging what amounted to 4.25% in annual fees. Meanwhile, the average fund-of-fund was charging the equivalent of 6.50%.

"So imagine that: Investors are lopping off between 4.25% and 6.50% from the start. And they think they're getting brilliant managers, which they aren't. On top of that, there's no transparency and investors are locked into these hedge funds for however long they decide to limit redemptions," said Patti.

Lower Volatility & Noncorrelated Returns

Although hedge funds these days are finding it more difficult to provide excess alpha over the market, they can still provide noncorrelated returns and low volatility. "So they're still good for diversification. What they're providing essentially is alternative-market-like exposure," said Davidow.

Such so-called "alternative beta" can be replicated through the use of common, liquid securities, he added. "What we've done is analyze the risk-return characteristics of underlying hedge fund strategies. While we'd argue that the alternative beta is valuable, it's not worth the high fees hedge funds are charging," said Davidow.

IndexIQ analyzes hedge fund performance data. Then, the firm's analysts match those characteristics to a combination of different ETFs in the market that would provide a similar performance profile. To do that, the firm considers common asset class exposures divvied up among the six main categories. "So an emerging markets hedge fund could have very similar types of asset class exposure as an emerging markets ETF," said Patti.

The hedge fund manager might be long or they might be short with those same holdings, however. And similarly, certain hedge fund styles might be implementing different relative value trading maneuvers. "Whether they're a hedge fund or an ETF, both are likely starting with the same general base of assets within the categories as the data providers define it," said Patti.

The key, he adds, is how those relative value traits and asset class exposures are weighted in the index. "If you're a fund-of-funds hedge fund, the best you can do is to have zero exposure to long-short strategies," said Davidow. "But by using large, liquid ETFs, we can actually be long or short. So by building an index component by component, we can actually gain short exposure, something fund-of-funds hedge funds can't really do."

That's helped lately, since long-short fund-of-hedge-fund managers have performed poorly over the past 12 months. "We've been able to short that strategy in the benchmark, which has helped us to do very well compared to the fund-of-funds benchmarks," said Patti.

Real-time data for the IQ Hedge Multi-Strategy Index shows total returns of -1% so far this year. In the past five years, the benchmark has gained an average annualized 6.05%—with just 7% annual volatility. That compares to the S&P 500's -2.2% with volatility of almost 13%, says IndexIQ.

IndexIQ's analysts consider two different hedge fund benchmarks along with the S&P 500 for evaluating their performance. Those performances over the past five years through 2008 are:

• The CS/Tremont Blue Chip Index has returned an average annualized -1.09% with 7.85% average yearly volatility.

• The HFRX Global Hedge Fund Index has lost -1.61% with 7.26% volatility.

[Editor's Note: The ETF launched just after 2:00 p.m. Eastern time on Wednesday, trading more than 9,000 shares in the initial going.]