Fund name: IQ Alpha Hedge Strategy Fund (no ticker)

Objective: the fund seeks to match, give or take expenses, the performance of the IQ Hedge Multi-Strategy Index. The index uses ETFs in an attempt "to replicate the risk-adjusted return characteristics of the collective hedge funds using multiple hedge fund investment styles, including long/short equity, global macro, market neutral, event-driven, fixed income arbitrage and emerging markets." It does not, however, actually invest in hedge funds and it does not mimic the hedge funds’ investments. The objective of the Index is to provide higher returns than the S&P500 with lower volatility and a correlation (R-squared) comparable to that of hedge funds.

Adviser: IndexIQ Advisors, LLC. IndexIQ has been licensed as an investment advisor for less than two years and "has limited experience as an investment advisor." It offers a mutual fund and an ETF, plus separately managed accounts. It’s a wholly-owned subsidiary of Financial Development HoldCo, LLC, which is the entity responsible for developing the index and the strategy.

Manager(s): a team from Mellon Capital Management led by Denise Krisko. Ms. Krisko is co-head of Equity Index Management for Mellon, which manages $220 billion in assets.

Management’s Stake in the Fund: none yet reported. Given that Ms. Krisko and her team are mercenaries of a sort, it’s possible that they will not invest in the fund.

Opening date: May 31, 2008.

Minimum investment: $2,500 for the retail fund version.

Expense ratio: expenses are temporarily capped at 1.64% for the retail fund version. The ETF version has a 0.75% expense ratio plus another 0.34% estimated expenses for the underlying funds. The fund version has a 2% redemption fee on shared held for less than a week, which might be just enough to keep certain traders at bay.

Comments: this is a very confusing product with a very appealing sales pitch. I’d be particularly conscientious about my due diligence before proceeding here.

Here’s the sales pitch: hedge funds, as a group, provide an important service. They have the prospect of performing at least as well as the stock market with lower volatility and modestly reduced R-squared values. That is, hedge funds won’t necessarily tank when the market does. Competitive returns plus a modest correlation with one’s more conventional investments means that they offer the prospect of adding "alpha" to a portfolio. That is, a portfolio with a dose of hedge funds has a better risk/return profile than one without.

Hedge funds, the IndexIQ folks warn, also have serious downsides. They charge a lot for their services (2-4% of assets plus 20-40% of profits) and the talent pool got stretched mighty thin as the number of hedge funds grew from under 100 to over 9000 in a single generation. That means that unless you’re able to access one of the superstar managers, you face considerable "manager risk."

IndexIQ offers you all of the good parts of hedge fund investment with none of the bad parts. Their investment minimums are low and their expenses are low, at least relative to hedge fund expenses. Best of all, they eliminate manager risk by using secret formulae to replicate the returns of the entire hedge fund universe rather than trying to mimic the investments of a single individual hedge fund.

Their five-year backtest of the index (linked below) reveals a glorious investment: their index would have returned 8.96% annually between 1/2004 and 12/2008. At the same time, the S&P500 and two of three hedge fund indexes were underwater. The one winning index – CS/Tremont – returned less than half of the IQ Alpha hedge index. In practice, their mutual fund lost 10.14% between inception and 1/31/2009 while the hedge fund indexes lost 22-24% and the S&P500 dropped 34.5%.

How exactly they do that is unclear. The fund and ETF both invest, primarily, in other ETFs. Some of those can be inverse ETFs (i.e., they short a market segment). The portfolio is also leveraged, giving investors something like a 130% exposure to the underlying index. Leverage could go to 200%, according to the portfolio. For now, though, they’re thirteen, mostly broad-market funds. Over one-third of the mutual fund is invested in the Vanguard Total Bond Market and another third was the iShares Short-term Treasury Bond fund. Somehow having 94% of your money in four bond funds, 10% in emerging markets, 5% in REITs and 5% in currencies plus a 22% short position in stocks and emerging market debt gives you returns equivalent to investing in hundreds of (event-driven, market-neutral, global macro-event...) hedge funds.

It’s understandable that the index’s formulators aren’t going to be sharing much by way of detail. They warn, for example, that "some details concerning the Index’s methodology are likely to remain confidential such that none of the Investment Advisor, the Sub-Advisor [i.e., the managers] or the Fund’s shareholders" will have access to too much information concerning how the index components vary over time.

To their credit, the advisors have posted a wealth of research on their website and sophisticated readers might gain a lot from spending a long afternoon with it. At the end of my own reading, I still was not capable of quite understanding the nature of the magic these folks were performing.

Which, I guess, is the mark of a good magician.

Bottom Line: the prospectus warns "the Fund should be considered a speculative investment entailing a high degree of risk and is not suitable for all investors." I suspect they’re right.