By Amy Feldman November 25, 2009

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.

Some of these new products are actively managed, while others take a passive approach. They run the gamut in terms of strategies they try to replicate at lower cost. The competitive rush to create new products quickly risks pushing some bad products onto the market, or leaving some new alternative funds and ETFs without enough assets to be viable. But investment strategists, analysts, and academics believe that diversifying beyond stocks or bonds and having the flexibility to bet whether an investment will gain or fall in price will help investors get protection against volatility. We think that the investment landscape has changed permanently, Lo says.

With investors jolted by last year’s market meltdown, alternative funds have been gaining assets rapidly. Flows of new money into hedge-like products added $5.4 billion in the first nine months of 2009, atop a $5.7 billion net inflow in 2008, according to Financial Research Corp. Assets now total $39.9 billion. IndexIQ’s multi-strategy ETF, launched in March, had $40 million in assets by August; by November, assets had almost doubled to $74 million. In the ETF space, the first mover wins, Patti says. If you miss being the first mover by one day, you lose.

Adam Patti, 38, is a serial entrepreneur who found himself in the right place at the right time. In his 20s he had been an investment banker, founded a supply-chain software company that failed when the dot-com bubble burst, and started another company that analyzed business processes of small- and midsize manufacturers, which he sold to a group of employees and investors. In 2000 he landed at Time Inc. (TWX) as associate publisher for its Business and Finance Network. While there, he worked to create investable indexes such as one that tracked the Fortune 500 list of companies. Six years later, with the ETF industry booming, he co-founded IndexIQ with the notion of expanding the index approach to alternative asset classes. Indexing had not really evolved since the 1970s, says Patti. We thought we could bring value to investors with alternatives. That was the crazy idea.

Actually, it was a pretty straightforward idea but tough to execute. High-net-worth investors had been adding alternative asset classes to their portfolios with hedge funds, but few regular investors were qualified to invest in hedge funds, and those who did faced high fees and restrictions on when they could take money out. So there seemed a clear need for Patti’s crazy idea. But how to marry the concept of indexing with alternative assets was not clear at all. Hedge-fund data is problematic, and there isn’t an existing index of hedge-fund returns that’s remotely equivalent to the S&P 500 for stocks. IndexIQ decided it needed to come up with a way to create customized indexes and build portfolios based on them.

TAKING EMOTION OUT OF ITTo do that, Patti and his 16-person team brought on Robert Whitelaw, a finance professor at New York University Stern School of Business, as its chief investment strategist and intellectual heavyweight. Whitelaw and Salvatore Bruno, his research counterpart inside IndexIQ, created six investment strategies for each of the main hedge-fund strategies, such as global macro or equity long/short.

To turn those indexes into its first multi-strategy fund and ETF, IndexIQ ran computer models to help decide which of the six strategies should get more money, and which less. The resulting mix gets rejiggered monthly, keeping within strict parameters, such as not moving any strategy by more than 10% within a month, to help control volatility. Fees on the ETF run 75 basis points; the mutual fund’s expenses run 1.4%.

One money manager early to see the potential in IndexIQ’s approach was David Garff, chief executive of Accuvest Global Advisors of Walnut Creek, Calif. Garff had been struggling to create his own hedge-fund replication product for clients when he heard about IndexIQ. In July, Accuvest began adding IndexIQ’s multi-strategy ETF to the portfolios of its largely Latin America-based high-net-worth individuals and foundation clients. Garff says his clients have more than $10 million in that ETF and the new inflation-tracking product. We were early adopters, he says. We are not done by a long shot with those guys.

Patti and his distribution chief, Anthony Davidow, formerly with Morgan Stanley, expect the inflation-tracker ETF to be a hit. Investors have flocked to Treasury Inflation-Protected Securities, or TIPS, yet the volatility of TIPS makes them problematic for those worried about short-term inflation. TIPS were designed to protect against inflation when held to maturity. IndexIQ’s ETF seeks to create a liquid portfolio that can protect against short-term inflation.

How big a deal could these new products become? With worldwide mutual fund assets topping $20 trillion, if even a sliver moved to alternatives the amounts invested would be astronomical. The ETF industry is growing so fast, and there are no established players on the alternative assets side, says Morningstar (MORN) analyst Bradley Kay. There is a lot of excitement about alternatives.