A new player in the ETF industry, IndexIQ, made a splash with today’s launch of a first-of-its-kind “hedge fund replication” ETF. According to the press release, the IQ Hedge Multi-Strategy Tracker ETF (QAI) will attempt to replicate broad hedge fund returns with low volatility and low correlations to equity markets.

The underlying index attempts to capture the risk-adjusted return characteristics of the hedge fund universe. The multiple strategies employed include long/short equity, global macro, market neutral, event-driven, fixed income arbitrage, and emerging markets.

The ETF will not invest in hedge funds. Instead, it will invest in other ETFs with the intent of overcoming many of the drawbacks of traditional hedge fund investing. IndexIQ states that using an ETF-based approach will allow QAI to provide intra-day liquidity, portfolio transparency, lower fees than the typical hedge fund, and the elimination of manager-specific risk.

The fact sheet has additional information, including the results of the 5-year hypothetical backtest. QAI is an ETF of ETFs, therefore its 0.75% expense ratio is in addition to the expense ratio of the underlying funds (which will vary over time as holdings change). This is an actively managed ETF, so returns will also be reduced by the cost of implementing the strategy (transactions and slippage). Before adjusting for expenses and costs, the backtest shows a 5-year return of +6.1% versus -2.2% for the S&P 500 at about half the volatility. The 5-year alpha was +6.7%.

We welcome this addition to the ETF marketplace. Although the product is not likely to attract the high volumes associated with ETFs designed for the trading community, it is unique enough to attract the attention of longer term investors.

Information on the bid/ask spread was not available during the first couple hours of trading this morning, but shortly after 1pm (EDT) the first trade crossed the wire at $25.19. There were more than 27,000 shares traded today, and the bid/ask spread typically ran about four cents.

Although the stated intent of QAI is to replicate the performance of the hedge fund universe, there are many strategies employed by hedge funds that cannot be duplicated with the current universe of ETFs. For example, most “event-driven” strategies, such as merger arbitrage, require taking positions in individual securities. Convertible arbitrage is another example of a hedge fund strategy that cannot be implemented using just ETFs.

The underlying index, and therefore the ETF, is reconstituted on a monthly basis. While this is more frequent than most ETFs, it is not the same flexibility that hedge fund managers enjoy. Additionally, while QAI will have the built-in tax efficiency provided by the ETF structure, these monthly changes to the holdings will likely result in larger distributions than the more common passive ETFs produce.

IndexIQ also states that this offering eliminates manager-specific risk. Perhaps that is true in a sense, given that the job of the underlying ETF managers is to track an index. On the other hand, each ETF holding does indeed have a manager, and therefore such risk is still present. The recent problems surrounding the premiums and bid/ask spreads of the Credit Suisse ETNs and the bankruptcy of the Lehman ETNs are just two examples. Furthermore, IndexIQ is now a source of manager-specific risk because they designed the index, the methodology, and manage the implementation.

Caveats aside, this is likely to be one of the best new offerings of 2009. It is an ETF that certainly deserves consideration. I know that I will be monitoring its progress.