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The rise of ETFs has led to the democratization of many asset classes which were once reserved for the ultra-rich. While investors have quickly adapted to ETFs offering exposure to commodities and quantitative strategies, another alternative asset has also seen a recent surge in popularity. Traditionally, hedge funds have been known for their ability to deliver strong returns with low volatility and low correlations to other asset classes. These returns often come in return for big fees; hedge funds generally charge 2% of assets per year plus 20% of profits, enabling fund managers to live handsomely off of profitable investments. Furthermore, some hedge funds require that their investors earn a minimum amount of money annually and have a net worth of more than $1 million, thereby limiting the universe of available investors.

When the first ETFs designed to replicate strategies traditionally employed by hedge funds were introduced last year, some investors were skeptical. But these funds have steadily gained traction, becoming increasingly popular with a variety of investors (see Will Hedge Fund ETFs Replace Hedge Funds?). In addition to reduced expenses, hedge fund ETFs offer significantly lower investment minimums, increased transparency, and the security of knowing that ETFs are subject to oversight by various regulatory agencies.

The original (and most popular) hedge fund ETF is the IQ Hedge Multi-Strategy Tracker ETF (NYSEARCA:QAI), which now has nearly $90 million in assets, suggesting that investors have become comfortable with the unique methodology and investment strategy behind this vehicle. Below, we take a look at QAI “under the microscope” in order to find out what makes this fund tick.

Index

The fund tracks the IQ Hedge Multi-Strategy Index, a benchmark that attempts to replicate the risk-adjusted return characteristics of hedge funds using a wide variety of investment styles. These strategies include long/short equity, global macro, market neutral, event-driven, and fixed income arbitrage. The general strategy behind QAI is relatively simple; analyzing the risk and return characteristics of popular hedge fund styles allows the creation of an index that will exhibit a strong correlation but is composed exclusively of transparent and liquid ETFs.

Of course, implementing this strategy takes a significant amount of research and analysis. QAI relies on a proprietary, rules-based quantitative methodology that first screens the universe of U.S.-listed ETFs by asset class exposure and liquidity requirements. The correlation of each eligible ETF is then calculated relative to returns of certain hedge fund strategies (as measured by publicly-available benchmark data). Using this score (along with a ranking for degree of overlap of investment strategy and asset class), each ETF is ranked. The ETFs with the greatest relevance to the hedge fund strategy are then included in multiple backtests to calculate various stats using components in different combinations (read a complete breakdown of the hedge fund index construction process here).

Because the index underlying QAI is designed to replicate a variety of hedge fund strategies, it is constructed by combining multiple sub-indexes, each of which is developed in accordance with the methodology discussed above.

Portfolio

QAI has the latitude to invest in a variety of asset classes, including real estate, domestic and international equities, and fixed income. A current snapshot of holdings reveals some interesting trends. The fund has a tilt towards emerging markets and high-yield bonds; EEM, VWO, JNK, and HYG are all among the top six holdings. In aggregate, these four funds make up slightly more than 25% of total assets. The largest holding is the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD), which accounts for about 27% of assets.

Bond ETFs account for more than half of QAI’s assets, with emerging markets equities accounting for another significant chunk. It’s interesting to note that domestic equities receive only a minimal weighting. Other interesting holdings in the top ten include PowerShares DB G10 Currency Harvest Fund (NYSEARCA:DBV), which is currently the fourth largest holding of QAI.

Returns and Fees

To date in 2010, QAI is essentially flat, and is up about 8% since its launch nearly a year ago. Perhaps more importantly, however, is QAI’s correlation to stocks and bonds (as measured by SPY and AGG, respectively). During the fund’s relatively short operating history, it has exhibited a relatively low correlation with both of these funds (approximately 0.60 with SPY and slightly negative with AGG). In an environment where correlations between global equities (and even bonds) have shot towards 1.0, adding non-correlated assets is both increasingly difficult and increasingly important.

QAI

Disclosure: No positions at time of writing.

Source: QAI: Under the Hood of a Hedge Fund ETF