(Editor's Note: The following is ex-Morgan Stanley analyst Paul Mazzilli's monthly research note for IndexIQ and part of the firm's latest ETF Insight newsletter.)

In May, equities rallied for a third consecutive month for the first time in many years. The S&P 500 Index was up 5.6% for the month, and has now reversed the sharp losses of January and February (up 3% YTD). We believe that the worst of the recession may be behind us, and we are starting to see signs of improving fundamentals. History indicates that the equity markets tend to hit bottom in the middle of a recession and historically have posted significant returns over the following year. Thus, we believe that investors who wait for the economy to improve before buying stocks could miss significant gains. In this changing environment, financial advisers and investors continue to seek ETF strategies that will perform well and add portfolio diversification.

After dropping throughout the first quarter, net ETF assets are now up over $55 billion for the year due to net cash inflows of $29 billion and the recovery of the equity markets since March. Although there have been a number of interesting new filings, the actual issuance of new ETFs has slowed and has more than been offset by a much higher than usual number of liquidations. Interest in traditional equity ETFs continues to wane this year with total outflows of $35 billion. There were also net outflows in ETFs investing in developed international markets but renewed interest has resulted in strong inflows to broad emerging market and Brazil and China ETFs.

• In contrast to equities, Fixed Income ETFs had net inflows every month this year with another $4.1 billion in May bringing YTD net inflows to almost $20 billion.
• Leveraged and Inverse ETFs still show significant growth. Although there are issues regarding tracking error and tax efficiency, they attracted $19 billion in new flows in 2009, as these types of ETFs continue to be favored by active traders.
• Investors continue to embrace ETFs as an efficient means of gaining exposure to alternative asset classes. Commodity ETFs had over $18 billion in net cash inflows this year and SPDR Gold, which took in $11.8 billion, is now the second-largest US-listed ETF, with over $35 billion in total assets.
• Hedge Fund ETFs are now available that seek to provide the diversification benefits of hedge funds without their structural impediments, namely lack of liquidity and transparency,[1] and high fees.
• IndexIQ’s IQ Hedge Family of products seeks to replicate the risk and return characteristics of hedge funds by using factor and quantitative analysis. We use ETFs in the portfolio as proxies for the common factors driving hedge fund returns. IQ Hedge products seek to replicate the various hedge fund styles (Global Macro, Emerging Markets, Long/Short, Market Neutral, Event Driven and Fixed Income Arbitrage).
• The IQ Hedge Multi-Strategy Tracker ETF (NYSE Arca: QAI) may serve as a core holding for larger investors seeking allocation to hedge fund strategies given its alternative beta exposure. For smaller investors, I believe QAI is a way to efficiently get exposure to this asset class.
• The IQ Hedge Macro Tracker ETF (NYSE Arca: MCRO) was just launched as the first ETF designed to replicate the risk and return characteristics of global macro and emerging markets hedge fund strategies. These two strategies have been shown to historically perform well after market dislocations.[2]

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