Beyond Stocks & Bonds November 25, 2009, 5:00PM EST

'Hedge Funds' for Everyone

The market meltdown highlighted the risk of investing in only stocks and bonds. A new wave of funds make it easier for average investors to diversify

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In late October, IndexIQ Chief Executive Adam Patti was crisscrossing the country, from Seattle to Baltimore, giving his spiel about the firm's new alternative investment products to financial advisers in a 20-city road show. The Rye Brook (N.Y.)-based asset-management startup had recently launched two new exchange-traded funds (ETFs), one that tracks inflation and another that invests in a portfolio of global commodities. The firm's flagship product, the IQ Hedge Multi-Strategy Tracker ETF (QAI), which aims to replicate various hedge fund strategies, had opened eight months earlier and attracted $74 million in assets.

For years academics and institutional wealth managers have talked about why the typical approach of many individuals to diversification—splitting assets between stocks and bonds—wasn't good enough. But it took the market meltdown for many investors to see just how much volatility, and risk, they were actually taking on by investing in only two asset classes. Now a handful of money managers are launching mutual funds and exchange-traded funds to bring alternative investments to the masses. The appeal: a chance to earn higher returns, dampen volatility, and lower risk. High-net-worth individuals and pension funds are also finding uses for these investment vehicles because of their liquidity and transparency compared with actual hedge funds.

IndexIQ, a startup asset manager that creates its own indexes and then models investment portfolios based on them, is one of those newcomers. Over the past 18 months, it has launched five ETFs and one mutual fund that aim to replicate hedge-fund returns, give investors protection against inflation, and let them participate in merger-arbitrage opportunities. It has received regulatory approval for another dozen ETFs it plans to begin rolling out this winter. While the company's total assets are tiny, at around $200 million, its executives have plans to change the investing landscape in as dramatic a way as Vanguard Group did 30 years ago with index funds. "Our mandate is audacious: We want to be the Vanguard of alternative investments," Patti says. "Why should it be only sophisticated investors who get full diversification?"

Historically, access to alternative investments had been limited to institutional and high-net-worth investors who had hedge funds or separately managed accounts, which are personalized portfolios for wealthy individuals run by financial advisers. But academics had been struggling with the question of how to measure and capture "alternative beta." That is the portion of investment returns from alternative asset classes, such as those held in hedge funds, that is tied to the asset's underlying market. The return that is a result of a manager's skill is known in financial parlance as "alpha." The evolution of equity index funds such as those tied to the S&P 500 had allowed investors access to the equity market's performance, or beta return, at low cost. But when you move beyond stocks to oil or merger arbitrage or hedge-fund returns overall, the issue becomes: What exactly is the beta return? With no investable index to function as a benchmark, how do you create a portfolio that captures a market's return?

IndexIQ is not alone in asking those questions. AlphaSimplex Group, an asset manager started by Massachusetts Institute of Technology finance professor Andrew Lo and owned by fund conglomerate Natixis Global Asset Management, brought out its first mutual fund, Natixis ASG Global Alternatives Fund, in September 2008. The fund, with $161 million in assets, uses futures and forward contracts to get investors exposure to global equity, interest rate, currency, and commodity markets. In October, ETF giant iShares, which has more than $300 billion in assets, launched its own hedge-fund replication product, iShares Diversified Alternatives Trust. Other players in the field include Goldman Sachs (GS), WisdomTree Investments (WSDT), and PowerShares.