(Dow Jones) A new exchange-traded fund promises to mimic hedge-fund strategies in an easily traded and lower-fee vehicle, but investors may want to see how this second-generation ETF fares in the real world before rushing in.

IQ ARB Merger Arbitrage ETF, which listed on the NYSE Arca earlier this month, is one in a growing field of ETFs that blur the lines between active and passive management. It follows a rules-based index that approximates a merger-arbitrage strategy employed by some hedge funds and mutual funds.

The ETF's manager, Rye Brook, N.Y.-based IndexIQ, also oversees so-called hedge-fund-replication ETFs, as well as mutual funds and separately managed accounts. It's a relatively small firm with about $200 million in assets, and it also runs the indexes its ETFs follow.

The IQ ARB Merger Arbitrage ETF rolls out at a time when global mergers and acquisitions are expected to pick up again after deal volume came to a crashing halt during the financial crisis. Markets are beginning to firm up a bit, and some companies are sitting on piles of cash.

Merger-arbitrage funds typically invest in M&A deals by going long the target's shares after a deal is announced, and occasionally shorting the acquirer's stock. The funds profit from the spread if the transaction closes, but the risk is that the deal falls apart, which can happen for many reasons.

Because an ETF's holdings must be relatively liquid for it to trade properly, the new ETF takes a watered-down approach. Rather than shorting the acquirer's shares, it uses other ETFs to get short exposure to broad-market indexes such as the S&P 500 Index and MSCI EAFE, which is a proxy for international developed-market stocks.

The ETF's index, which is rebalanced on a monthly basis, hunts for target companies in acquisition, merger, leveraged buyout and private equity deals around the globe. Eligible deals must have more than 50% ownership sought by the acquirer. At the monthly rebalance, no stocks can make up more than 15% of the index. 

 
Short Notice

Essentially, the ETF's benchmark tries to "bake in" the techniques used by merger-arbitrage fund managers with an objective, rules-based methodology.

Adam Patti, chief executive at IndexIQ, said the index is designed to avoid deals in which the acquirer makes a "low-ball" bid. It also overweights the most liquid deals, which helps the ETF trade within a narrower spread. Emerging markets stocks are excluded.

The tracking index also has about 30% in cash by holding iShares Barclays Short Treasury Bond Fund, so it's not fully invested in stocks. The ETFs in the portfolio that short the stock market are ProShares UltraShort S&P 500 and ProShares UltraShort MSCI EAFE.

Bradley Kay, an ETF analyst at investment researcher Morningstar Inc., said the fact that the ETF shorts market indexes, rather than the acquirer's shares, is a key difference from "merger-arb" mutual funds such as the Merger Fund and the Arbitrage Fund.

As a result, the ETF may have a greater correlation to the market, he said, which would reduce its effectiveness as a portfolio diversifier. The approach could also lead to more volatility than a pure merger-arb strategy.

In a stock-for-stock deal, merger-arb funds often short the acquirer's stock to hedge and lock in a defined spread. Shorting the acquirer's shares is also a source of return, Kay said, because they often overpay for targets. The acquirer's shares can also be punished if it is outbid by another company, the analyst said. Finally, he pointed out that the most liquid M&A deals favored by the ETF tend to have the narrowest margins.

"When you do a general market hedge rather than shorting the acquirer's shares, it's no longer a precise arbitrage transaction," said Jonathan Schonberg, product specialist at Water Island Capital, the advisor to the Arbitrage Fund. "It doesn't really equate to classic merger arbitrage the way we employ it." 

 
Tax Matters

Kay, the Morningstar analyst, said despite some drawbacks, the new ETF has certain advantages over merger-arb mutual funds. The most obvious is lower fees -Q ARB Merger Arbitrage ETF has an expense ratio of 0.75%. The Arbitrage Fund currently has fees capped at 1.69%, while the Merger Fund has a gross expense ratio of 1.54%.

Also, for taxable accounts, the ETF structure offers better tax efficiency for a high-turnover strategy, he said. On the other hand, the merger-arb mutual funds have well-established track records. The Arbitrage Fund has been operating for almost a decade, while the Merger Fund has been around for 20 years.

"We'll have to wait and see if the ETF's fees and tax benefits can overcome some of the limitations," Kay said. 

 
Hedge Alternatives

IndexIQ earlier this year launched ETFs that seek to replicate hedge fund strategies: IQ Hedge Macro Tracker ETF and IQ Hedge Multi-Strategy Tracker ETF . The goal is to capture the overall performance of hedge funds that use various approaches.

The shift in ETFs away from plain-vanilla index funds to increasingly complex strategies gives investors more choices, but it also means doing more homework.

The newer generation of ETFs that employ hedge-fund-like strategies includes ProShares Credit Suisse 130/30, PowerShares S&P 500 BuyWrite Portfolio and iShares Diversified Alternatives Trust.

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