Hedge Fund Story

How ETFs got the better of hedge funds, globally

What would be the biggest investment story of the last decade? Forget about gold, oil and equities. The biggest story has been the way exchange traded funds (ETFs) have overtaken hedge funds in terms of assets under management (AUM). Consider the numbers! Back in 1999, ETFs were less than a 10th of the hedge fund industry. Currently, ETFs have an AUM of $3 trillion, a tad more than the hedge fund industry. How did this shift happen?

It’s all about the sub-prime crisis…

The real growth of ETFs came post the 2008 sub-prime crisis. As brokers recklessly sold toxic mortgages to hedge funds, it was great till the honeymoon lasted. Post the crisis; the sub-prime meltdown raised serious questions about the ability and commitment of hedge funds. Why would somebody pay exorbitant management fees to a hedge fund for managing assets in such a shoddy fashion? Not surprisingly, during this 6-year period the AUM of ETFs has grown 4-fold from $750 billion to $3 trillion. Hedge funds struggled!

Last 6 years was all about macros…

Even as hedge funds continued to focus on alpha (excess return) and complex derivative strategies, things were changing. The world markets were becoming a series of interlinked macro plays. This was more so because globally monetary policy was become more and more synchronized. In this situation, the ETFs could play themes best with the help of indices. These low-cost vehicles made a lot more sense compared to the high cost hedge funds. Over the last 6 years, the average rolling return of hedge funds has been in the range of 3-6%. That is hardly anything to write home about.

Look at the cost differentials

At the end of the day, it boils down to the costs. For an average ETF the costs could be as low as 0.05%. Compare that with hedge funds, which charge a 2% management fee and a 15-20% share in profits. That hardly makes sense to the investor unless you are able to consistently generate alpha! That is something very few hedge funds have managed in the last 6 years.

Size was a problem for hedge funds

At the end of the day, size became the real problem for hedge funds. ETFs don’t rely on alpha and hence can absorb a lot of money. Hedge funds cannot function in an overcrowded market. The scope for alpha will be extremely limited when there is $3 trillion of smart money sloshing around. That was the crux of the problem for hedge funds. This trend seems be an extrapolation. We may see the ETF AUM at a multiple of hedge funds within the next 10 years. As for investors, they will surely be better off! ©

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