Q&A: Hedge Fund Replicator Earns Its Stars

Aug 10 2011 | 4:04pm ET

For its third birthday, IndexIQ's flagship open-end, no-load hedge fund replication mutual fund got what every young mutual fund craves—a five-star rating from Morningstar Inc. The IQ Alpha Hedge Strategy has managed a 5.73% return since its inception. FINalternatives spoke to CEO Adam Patti about the origins of his company, his love for exchange-traded funds and his mission to “democratize alternatives."

What is your background? What are the origins of IndexIQ?

Right before I started IndexIQ I was working at Time Warner. One of the main things I was doing was running a business unit called Fortune Indexes, which was the indexing operation related to Fortune magazine. We created indices based on Fortune magazine lists and worked with State Street Global Advisors to bring out ETFs based on those; we did that way back in 2000, really early in the ETF market. Those products were the first non-market-cap-weighted indexes, what people now call “fundamental” indexes.

Our flagship product was the Fortune 500. The interesting thing about it was that it outperformed the Standard & Poor's 500 Index over most timeframes going back 50 years, with lower volatility and higher dividend yields. So that’s kind of when the light bulb went off

So, long story short, I pulled the team out of Fortune Indexes and started the company in 2006. The goal was, really, to democratize alternatives and try to apply these index-based methodologies to more sophisticated institutional class alternative strategies and in doing so, add value for investors, improve transparency and liquidity, reduce fees and improve tax efficiency. I thought if we could do that, and offer it wrapped in an ETF structure, that might be the Holy Grail. I’ve been smitten with ETFs since I started working with them early on. I think they’re the universal tool.

We’re really a research-driven organization. Most ETF issuers out there, they license indexes from others and then package them and sell them; they’re really more sales-driven. We develop everything ourselves and to do that, we knew we had to hire some really good research people. We attracted Professor Robert Whitelaw, who is chairman of the finance department at New York University, to be our chief strategist. He’s been with us since day one, and we brought on some additional academics to fill out our academic advisory board. Then we built out our core research team—we hired Sal Bruno, who was the former global head of quantitative research at Deutsche Asset Management, and we built around him and that’s the organization.

How do you construct one of your hedge fund replication funds?

The issue is that you’ve got as many hedge fund managers as you have mutual fund managers, and we all know that 85% of active mutual fund managers underperform their benchmarks every year—because it’s tough! It’s tough to drive alpha. So the academics, including Whitelaw, in the ‘90s started looking at hedge fund returns and trying to determine what are hedge funds really providing. Lo and behold, what they’re providing is a lot of beta exposure, not that much alpha. Which isn’t surprising, again, because there are only so many market inefficiencies to exploit. Now what they found is that the beta the hedge fund managers are providing is actually very valuable, it’s a multi-asset class beta, it’s not S&P500 equity beta, it’s diversified stream of risk premia across different asset classes.

So then the question is, can you replicate that beta? And the answer is, "yes." The academics proved, beyond any reasonable doubt, that you can replicate what they were calling "alternative beta" by using liquid securities commonly used in the marketplace. And that’s what we are the leaders of the world in doing—we were the first firm in the world to launch a full family of indexes that replicate six of the top hedge fund strategies, from the market neutral to long/short equity to global macro and so forth.

These six hedge fund replication indexes have been calculated live by Standard & Poor’s since March 2007. Each one of these indexes uses ETFs in the portfolio as the proxies for the asset classes that hedge funds in those categories are using. We’re not trying to be a hedge fund, we’re not trying to beat hedge funds, we’re not trying to do any of that: We’re trying to be the hedge fund market.

Your flagship product is a mutual fund. How difficult is it to replicate hedge fund strategies within a mutual fund wrapper?

Each one of those six indexes covers one strategy; think of them as building blocks. The mutual fund is almost like a synthetic fund of funds. We’re always invested in all six of the strategies, it just depends on the degree. Just like a fund of funds manager will look at his or her managers and decide where the momentum is and who’s doing well, that’s exactly what the mutual fund does in a rules-based way—it looks at the momentum of returns, and the correlations and the volatility and based on that reallocates among those six strategies on a monthly basis.

You described ETFs earlier as a “universal tool." What is it you like so much about them?

The beautiful thing about ETFs is that they’re cheaper, typically, than mutual funds. You can buy and sell an ETF all day long because it’s pricing constantly, you don’t have to wait for the end of the day as with mutual funds. And most importantly, tax efficiency, particularly with a more sophisticated strategy like a hedge-fund-like strategy—neither one of those has ever paid out capital gains on portfolio turnover. So that’s a huge advantage.

How do your products fit into average portfolio? Who is target investor?

That varies a little bit depending on who you are, but generally, all investors now are encouraged to have some type of hedge fund allocation. The trick, of course, is how you get that hedge fund allocation if you can’t invest in hedge funds—that’s where our products come into play. Smaller investors or less-sophisticated ones could use QAI or MCRO or our mutual fund as their entire hedge fund allocation. All these products are designed to hedge volatility—to reduce volatility in a portfolio and provide upside potential when the market goes up but protect your downside,; they’re safety-type products, they’re not shoot-the-lights-out hedge fund products.

Others—more sophisticated investors or investors that have access to the best hedge funds in the world—can use our products simply as a cheap alternative beta core. Say you have 20% in hedge funds: Use our products for 10%, don’t pay alpha fees for beta performance, which is what you’re paying when you’re paying most hedge funds. Use us as the core and then find those really stellar managers as satellites.

We haven’t touched on the issues of transparency or liquidity yet, but I’m guessing those are significant selling points for your products.

It’s funny: When we launched the products initially—the mutual fund was the first one we launched—we thought it would be about fees, and then, all of a sudden, the world changed. Fees are not even on the table anymore—I mean, we have the cheapest fees in the world, I think, for our product. But it’s all about liquidity: "Can I get in and out when I want?" and "Do I know what I’m buying?"

Every day on our Web site—this speaks to the value of ETFs, but we also do it for mutual funds because it’s our philosophy—you can download the updated portfolio components, and understand exactly what you own, every day.

And also, with our index products, there’s no active manager so we have our rule book right on our Web site that shows you how the index is run. So every day you can see what’s going on and why something’s happening.

What does a Morningstar five-star rating mean to you?

It's validation that we’re trying to build quality products as a small company. We’ll never have 100 products out there. We have a very small number of products that we put a lot of care into building. We test them and we make sure they work before we launch them and I think the Morningstar rating really just proves what we’re trying to do is working and, I think, validates hedge fund replication. When we launched these products everyone thought we were crazy and now I think it’s becoming more mainstream.

How mainstream are these products now?

Well, when we launched it, nobody knew what it was; we’ve been out there educating people for three years, so I think advisors much better understand what we’re trying to accomplish and how you use it. I think the average person on the street won’t have any idea, but I think most advisors, at least advisors who use hedge funds, they’ll know what this is. That’s a big win for us.

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