NEW YORK ( TheStreet) -- For years, financial engineers have tried to develop index funds that track hedge funds. The appeal of indexing is clear. While individual hedge funds can blow up, many have delivered impressive gains. During the 22 years ending in 2008, the average hedge fund returned 14% annually, outperforming the S&P 500 Index by 8 percentage points, according to Hennessee Group. And hedge funds can diversify portfolios. Because they can sell short, betting on declines, the funds often outperform mutual funds during downturns. Designing an index fund has proved difficult because of the peculiarities of the hedge fund industry. To track the S&P 500, you simply buy shares in the 500 stocks. But it isn't possible to purchase a stake in each of the 9,000 hedge funds that exist. For starters, many are closed to new investors or require steep minimum initial investments. That's why hedge fund investors are usually millionaires. In addition, the lineup of funds constantly changes as new hedge funds open and others shut. Although no one has succeeded in precisely tracking the entire universe of hedge funds, several companies have recently introduced mutual funds that aim to provide broad exposure. So far, the funds have proved promising, limiting losses in 2008 and delivering positive results during this year's rally. One of the newcomers is Goldman Sachs Absolute Return Tracker Fund ( GARTX). During the fourth quarter of 2008, the fund lost 7% of its value, outdoing the S&P 500 by 14 percentage points, according to Morningstar. To manage the fund, Goldman starts by studying the returns of a group of 4,000 hedge funds. Then the company uses futures and other securities to build a portfolio that should closely replicate the group's results. The fund recently had 22% of assets in equities and 7% in commodities. Other holdings included cash and short positions in bonds. "The fund provides exposure to a composite of the hedge fund industry," says Glen Casey, a managing director at Goldman Sachs Asset Management.
Like standard index funds, Goldman Sachs Absolute Return cannot deliver alpha, the excess returns that star hedge funds produce. But the Goldman fund does have some noteworthy advantages, including lower fees. While Goldman charges an expense ratio of 1.6%, hedge funds typically charge an annual 2% management fee plus 20% of all profits. In addition, the mutual fund enables investors to make withdrawals every day. That's a big advantage over traditional hedge funds, which lock in investors for three months or longer. While the fund was designed for retail investors, Goldman's Casey says pensions and other institutions are expressing an interest. The institutions are considering placing a part of their hedge fund allocation into individual funds and the rest in an index tracker. Another mutual fund that outperformed during the downturn is IQ Alpha Hedge Strategy ( IQHOX), which gained 1% during the fourth quarter of 2008. To replicate the hedge fund inverse, IQ Alpha holds a basket of 15 or 20 exchange traded funds, including long and short positions in stocks, bonds, currencies and commodities. The portfolio recently had 21% of assets in iShares Barclays Aggregate Bond ETF ( AGG), 13% in iShares MSCI Emerging Markets ( EEM) and 7% in PowerShares DB G10 Currency Harvest ( DBV). "We use ETFs because we want to make it simple for investors to understand what we are doing," says Adam Patti, chief executive officer of IndexIQ, the fund's manager. Besides providing broad exposure to the hedge fund universe, ASG Global Alternatives Fund ( GAFAX) makes special efforts to control losses. If the market begins tanking, the fund will automatically employ a stop-loss mechanism, shifting to less-risky assets. "If our portfolio loses a certain amount within a short period of time, we will automatically reduce the volatility to protect the downside," says Andrew Lo, a portfolio manager who is a professor of finance at the Massachusetts Institute of Technology.
Lo's goal is to deliver results that are much less volatile than what investors can get with an S&P 500 fund. Since it started last year, the fund has succeeded in giving shareholders a relatively smooth ride. In the fourth quarter of 2008, the fund beat the S&P 500 by 19 percentage points. So far, the new hedge-fund trackers remain tiny. But Lo says they will grow into a major force. After being pummeled during the market downturns, investors are looking for ways to diversify their portfolios, Lo says. Because they don't necessarily follow either stocks or bonds, hedge-fund trackers could prove welcome additions to many portfolios. Lo predicts that expense ratios of the funds will drop sharply as they gain more assets over the next five or 10 years. Then the trackers could become as well established as S&P 500 funds are now.