A post-hedge fund world? Inspecting the ETF epidemic

Carol Loomis, a former American financial journalist, once wrote a famed Fortune article entitled: ‘Hard times come to the hedge funds’. This was a product of the 1970s, but it goes without saying that the world of stocks and investments experiences constant cycles: bear market, bull market, bear, bull, bear, bull and so on and so forth. Thus, Loomis’ assertion seemed destined to resurface, eventually.

It’s worth bearing in mind however that this era was not the grave end for the hedge fund, nor do they now appear as zombies reanimated by a differing financial climate; they have weathered the storm since the Loomis article days of yore and still remain. But, has the almost meteoric rise of Exchange-Traded Funds (ETFs) in the past few years seen the rebirth of the concept cynically dubbed the “hedge fund death”? Will we see a new dawn of investment world power? Time will tell it seems, but that time looks increasingly short.

Let’s take a closer look at the numbers. ETFs are primarily passively managed funds. In 2016, these attracted a net $563 billion according to Morningstar, whilst active funds (almost synonymous with hedge funds) suffered outflows of around $340 billion, a dismal trend which has continued into 2017. Last year also saw the closing of 530 hedge funds, almost a record high, which included such stalwarts as Seneca Capital and BlueCrest Capital Management.

One clear problem seems to be that, shown in an insightful article from Investopedia, hedge funds are both defined by a now-ancient 80s and 90s style of management, but also the Financial Conduct Authority (FCA) regards the ‘hedge fund’ as having “no universally accepted meaning” and the Security and Exchange Commission (SEC) say the term is “not statutorily defined”. It’s not great news when the regulatory outfits of two countries agree, is it? As another nail in the offshore-fund-coffin, the ETF industry was worth $4.17 trillion as of mid-2017, a trillion dollars greater than its hedge fund industry counterpart. Ouch.

The glowering support for ETFs doesn’t end there. At the end of the 2017’s first half, ETFGI reported that the global industry for ETFs and ETP(roduct)s consisted of 6,695 entries from 328 providers, listed on 70 exchanges in 56 countries. ETF returns from the S&P 500 Index have overshadowed those of hedge funds since 2011. Hedge funds’ infamously high costs are being grossly accentuated by those of ETFs, some charging as little as 0.3%. Famed ETF-offerers Vanguard and Charles Schwab seem to have perfected a low-cost model.

The evidence hereby seems to place (and hold) the investment world’s crown on the head of the ETF, but it is a reign that can indeed be volatile. Any financial professional is used to a fund’s precariousness; investing is a gamble. Such speculative phrases for an ETF are as follows:

These snippets are almost jokingly presented as archetypal comments from ETFs naysayers. On the whole, writers on ETFs are more balanced about how the capabilities of these trendy funds can outweigh the advantages of hedge funds if handled sensibly by both experienced investors, or those delving into low-cost passive investing for the first time. As if from an AMC TV series, Joel Dickson states…

“ETFs, like whiskey, require moderation. Moderation in use and moderation in the views pertaining to them.”
… and when corroborated by investment writer Karen Riccio…
“Smart for one investor can be downright stupid for another.”
…truly ETFs are not just a shotgun fashion trend moment. They are a viable alternative to the old-school, pricey and risk-heavy hedge fund market, and here’s exactly why.

ETFs are the hybrid mutant love-child of the mutual fund and a stock; a mixed bag. In addition, the multi-faceted fund also offers a swathe of options for investors that others on the market cannot, and makes diversifying investments a far more simple (and cheaper) endeavour. This is but one way in which they have become so popular for younger, more frugal investors mystified by the high fees offered by, say, actively managed hedge funds.

ETFs can house all of its advantages into just one stuffed investment package. The ETF ecosystem covers a range of asset classes, from stocks to bonds to real estate, all of which can be used as low-cost building blocks for a globally diversified portfolio. Indeed, ETFs let investors involve themselves in global markets (unlike individual securities), and they can be bought from as measly a fee as 0.05% a year.

Besides the obvious pricing benefits which ETFs have over their rivals, they are extremely transparent newscasters to their investors. Passive investments, by their very nature, mirror the performance of benchmark indices, and what with their listings on stock exchanges, holdings are published every single day with investors able to trade ETFs quickly without the threat of high commission costs. The liquidity of many funds allows them to be traded anytime (unlike index mutual funds) – a plus-point for the busy, on-the-go stockholder. Compare that to the listed holdings of mutual funds, which are usually published every 3 months – it’s very easy to track an ETFs performance, for better or worse (because, of course, despite the overall benefits of ETFs, the hefty smörgåsbord of them also brings with it a variety of successes and failures).

Limited to passive investment? Not the cheeky ETFs, which are moving towards traditional active management strategies with Active ETFs, an advancement on smart beta funds which set rules “by which managers abide” and expose investors to bespoke versions of benchmarks based on chosen factors, according to financial journalist David Prosser. Despite being around three times the price of ‘standard’ ETFs, they’re inexpensive enough to pose another threat to other active funds, and introduce initially passive fund enthusiasts to a more accessible active sector. That’s right: it’s hedge funds in the firing line again.

The ‘traditional’ tag could be viewed as slightly damning, particularly in the digitalised future we find ourselves heading towards in the financial services industry – an environment where ETFs thrive. As Wealth Management has discovered, the so-called AI Powered Equity Exchange-Traded Fund uses a set of algorithms to analyse thousands of stocks and around 10 years of data to forecast probability of returns and pick stocks with the highest potential to beat the market. Nifty! These data-driven solutions advocated by ETFs, to use a rather unnecessary buzzword, are known as “quantamental strategies”, and can use their digital power to cross-reference vast amounts of data faster than your average analyst. Given the fact that 5% of the asset management umbrella (over $1 trillion in AUM) is taken up by quant funds, mutual funds and smart beta products, these less traditional assets are clearly popular.

Nowadays, investors also come with a larger interest in ESG (environmental, social and governance) ETFs, particularly in Scandinavia and the Netherlands. In the past four years, the offering of ESG ETFs and ETPs has nearly doubled, spear-headed by such firms as UBS and BlackRock, meeting the overwhelming demand for “capital with a conscience”, a niche investment space which ETFs have provided. And to get more bizarre, the minefield of ETFs also offers up investment opportunities into beef and pork – the iPath Dow Jones-UBS Livestock Subindex Total Return Fund (COW) – alcohol, legal cannabis and a Quincy Jones streaming service. It is this strange plethora of options which almost diminishes the legitimacy of ETFs, but given the overwhelmingly ‘encompassing’ nature of ETFs compared to their hedge fund neighbours, this openness has, in turn, opened a lot of doors to new investing clientele. It certainly seems the former hold the majority of investment interest.

So, will this era mark the death of hedge funds? Much like the events of 40 years ago, they’re certainly a bit stuck-in-the-mud, but not without solutions. Roughly, as a PollRight survey dictates, 92% of senior hedge fund professionals predict an increasing usage of ETFs in their own industry; investors still enamoured with traditional strategies may adhere to these funds in order to juggle today’s “beleaguered investing zone”. Co-operation between the old-school and the new-school may be the perfect way to navigate a new fund frontier, a landscape very much infested with the enduring celebrities of the investing world, ETFs, who look set to continually grab the asset management tabloid headlines for the foreseeable future.