Why ETFs Are Slowly Killing Hedge Funds

It’s no secret that hedge funds love ETFs, but what’s less appreciated is that their love of ETFs will likely spell their demise.

Managing Editor
Reviewed by: Olly Ludwig
Edited by: Olly Ludwig

Total global ETF and ETN assets are about to exceed total assets in hedge funds, which means now is the time to begin playing a funeral dirge for many hedge funds.

That may sound like an outrageous assertion, so let me ease into it by way of a bit of crucial background.

First, to be clear, there’s a big and growing intersection between hedge funds and ETFs. In other words, hedge fund use of ETFs is significant and is becoming more so. In an immediate sense, that means in the chart below, provided by Deborah Fuhr’s London-based ETF consultancy ETFGI, some double-counting of assets has been baked into the numbers.

But that fact doesn’t preclude culling some important insights from what Deborah Fuhr is predicting.

ETF Exposure Superior

Most obviously, many hedge funds have grasped that accessing huge pockets of the financial markets using single ETFs as opposed to dozens of individual securities makes complete sense. It’s certainly cheaper to execute a global-macro view this way.

The 13F filings that big hedge funds have to make with U.S. regulators lay this bare. Big ETFs such as the SPDR Gold Shares (GLD | A-100), the SPDR S&P 500 ETF (SPY | A-98) and the Vanguard FTSE Emerging Markets ETF (VWO | C-85) are frequently the top holdings at hedge funds like George Soros’ or Ray Dalio’s Bridgewater Associates.

And to the extent that ETF product offerings are becoming more precise and plentiful, there’s less and less to be gained from relying mainly on individual securities.

Add to that the increasing liquidity of ETFs that has come with their rapid adoption in recent years, plus the ways that illiquid ETFs can still be traded efficiently, and hedge funds of yesteryear that plied their trade using individual securities really look like dinosaurs.

In the end, with ETFs, the world is potentially every investor’s oyster now, and turning on a dime in terms of big strategy changes has never been easier than with ETFs.

Performance Problems

The problems for hedge funds begin with the fact that ETFs are super cheap, while hedge funds are not.

The “2 and 20” fee schedule that has prevailed in the hedge fund world—2 percent of assets under management plus 20 percent of any profits generated on the investment strategy—is frequently the subject of derision these days. That’s because, by comparison, an ETF like the S&P 500 ETF “SPY” mentioned above, costs 9 basis points, or $9 for each $10,000 invested.

It would take more than 22 years of holding SPY to pay in fees the 2 percent piece of hedge fund fees would cost in a year—that’s not even accounting for the 20 percent of performance piece.

“In the past five years, you could have beaten most hedge funds by owning an S&P 500 ETF that costs 5 basis points,” Deborah Fuhr said.

“Investors are finding out that hedge funds have not been delivering the alpha that people had expected,” she added, noting that fees are the biggest reason for that.

Who Needs Hedge Funds, Anyway?

The fallout of this hedge-fund underperformance has already begun to manifest. A growing number of hedge funds, notably CalPERS, California’s huge public-employee pension fund, have dropped hedge funds from their lineup of investments.

This has created opportunities for other types of investors, notably so-called ETF strategists who create portfolios using only ETFs. Their fees vary, but are somewhere in the neighborhood of 1.00 percent plus fund fees. In the U.S, they now control around $100 billion in ETF assets, or just shy of 5 percent of total U.S.-listed ETF assets.

That’s plainly a lot cheaper than hedge funds, but ETF strategists have performance problems of their own, according to Fuhr. Those performance problems are related to their fees and also, at times, to active asset-allocation calls that have been off the mark.

That’s a topic for another blog on another day, but for now, all of these performance problems that Fuhr isolates serve to make clear the virtues of plain-vanilla, long-term, asset-allocation decisions based on a buy-hold-and-rebalance approach. Such an approach, particular with index ETFs, is dirt cheap, and for most retail investors, the most sensible.

At the time this article was written, the author held no positions in the securities mentioned. Contact Olly Ludwig at [email protected] or follow him on Twitter @OllyLudwig.

Olly Ludwig is the former managing editor of etf.com. Previously, he was a financial advisor at Morgan Stanley Smith Barney and an editor at Bloomberg News. Before that, Ludwig was a journalist at the Reuters News Agency in New York.