Hedge Funds Make the Move into the Indexing Marketplace

by: IndexUniverse

By Murray Coleman

Hedging and indexing aren't two strategies normally associated with one another in the mutual funds marketplace.

But last week, the IQ Alpha Hedge Strategy Fund started being sold directly by IndexIQ. As observed at the time (see article here), it's got a rather pricey expense ratio for a no-load mutual fund. That's going to give the fund a big headwind to fight coming out of the gates.

Managers of the Goldman Sachs Absolute Return Tracker Fund [GARTX] face an even bigger challenge. Like the Alpha open-end fund, GARTX follows an index of various hedging strategies. The fund came out a bit earlier on June 10. But it not only has a more hefty expense ratio than most index mutual funds, GARTX's key retail shares come with a load.

The Goldman Sachs fund's A-shares charge an expense ratio of 1.6% and come with a 5.75% load; the C-shares charge a 2.35% expense ratio without any loads.

Although both are index-based products, other key differences are apparent from the start.

"While we call our fund an index, it's not a completely passive index," said Robert Whitelaw, chief investment strategist at IndexIQ and a finance professor at New York University's Stern School of Business.

The IQ Alpha Hedge Strategy Fund seeks to replicate six sub-indexes. "We take the hedge fund data from various sources and we create standalone sub-indexes replicating performances of different strategies," said Adam Patti, chief executive of IndexIQ.

The Alpha fund's sub-indexes cover: long-short, market neutral, global macro, fixed-income arbitrage, even-driven and emerging markets.

"Since there are more than 9,000 hedge funds in the U.S., definite trends show up in the market. Managers are making very similar bets," Patti said. "You can identify those bets and replicate it through a rules-based index."

Once the sub-indexes were formed, IndexIQ created an equal-weighted composite index. "We knew the factor weights of the sub-indices, so we're basically aggregating those on the composite index's level," said Whitelaw.

The index they watch most closely besides their own is the Credit Suisse Tremont Blue Chip index of hedge funds. "The back-tested data shows very tight tracking to the Tremont index going back five years," Patti said.

The Alpha mutual fund takes the composite's portfolio and optimizes weightings using exchange-traded funds. "We overweight and underweight each of those six strategies to reduce correlation to the S&P 500," Patti said. "Our research shows that optimization also tends to produce better returns."

In the hedge fund world it's common for funds-of-funds to do much the same. Managers of this umbrella-type of hedge funds will buy varying amounts of individual hedge funds based on their particular take on the market. "The difference is our product is its strictly rules-based and it's fully transparent," said Patti.

GARTX sticks to passively tracking the Goldman Sachs Absolute Return Tracker index. "The GS-ART Index is not expected to have the same performance as actively managed products such as funds of hedge funds; it attempts to replicate the beta component only," according to Goldman Sachs.

Since both new funds will rebalance monthly, weightings can be expected to change frequently. But in the IndexIQ portfolio, by mandate one strategy can't represent more than 33% of its allocation. On the low end, it can actually go short the various strategies, up to a -16.67% position.

The fund's allocation as of May 31 was: a third in emerging markets; a third in event driven; a third in global macro; 13.33% in market neutral; 3.33% in fixed-income arbitrage and -16.67% in long/short strategies.

The result is that the IndexIQ fund functions somewhat like a 130/30 strategy, layering on additional alpha-seeking exposure while retaining 100% net long exposure to the market.

"The Alpha fund, based on back-tested data and real-time index data, would seem to provide slightly higher risk-adjusted performance and a little more volatility than the Goldman Sachs fund and its underlying benchmark," Patti said.

Unlike the IndexIQ fund, the index used by GARTX is based more on capturing beta performance than alpha. That means it focuses on volatility and trading ranges rather than trying to capture any outperformance of managers.

But like the Alpha fund, GARTX also uses sub-indexes to create a composite benchmark. Those come from other Goldman Sachs indexes covering hedge funds data relating to broad categories -- equities, commodities and fixed-income. Also tracked are hedging techniques based on credit and volatility measures.

The factors that comprise the GS-ART index are selected "from a universe of potential market exposures that contribute to hedge fund performance," Goldman Sachs says in the fund's prospectus.

Which ones it'll use are to be determined each October as part of the fund's annual selection process of underlying indices (or component market factors, as Goldman Sachs likes to term them).

GARTX also has a broader range of assets at its disposal. Those include futures, swaps, ETFs, commodity structured notes, stock and cash securities.

But IndexIQ argues that its practice of using only ETFs in the Alpha fund introduces more transparency into the process. "It helps to bring more liquidity into the hedge fund world and provides a better view of just what investors own," Patti said.

IQ Alpha Hedge Fund Holdings (5/31/2008)



Weight (%)


iShares Short Treasury Bond



Vanguard Total Bond



Vanguard Emerging Markets



CurrencyShares Euro Trust



iShares Lehman Credit Bond



PowerShares DB G10 Currency



PowerShares Emerging Debt



iShares Hi Yield Corporate Bond



iPath Dow Jones-AIG Commodity



iShares Lehman TIPS Bond



Vanguard REIT



iShares Russell 2000





Source: IndexIQ

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