Ease of use and open access, transparency, lower costs, and frankly better performance by ETF's compared to hedge funds is causing a massive shift in the way small and more importantly large institutions invest. Early in May, the amount of funds in global ETF's, which have only been around for just the past 22 years, topped $3 trillion. May also has marked the first time ETF's total asset value topped that of the 66 year old investment vehicle known as hedge funds, which currently sit around $2.9 trillion globally.
While mutual funds still dominate the investment world with more than $15 trillion in assets under US managed funds, ETF's certainly appear to be heading as the clear #2 in terms of total dollars invested. The industry has seen massive growth over the past few years, specifically in the US; 2013 US ETF assets rose by $188 billion, 2014 that figure jumped to $243 billion, and at the start of May year-to-date US inflow were already at $72 billion, which is a must faster start than experienced in 2014 when only $35 billion had been pumped into ETF's from the start of January to the beginning of May.
While the massive growth in ETF's over just the past five years is astonishing, due to the four qualities they offer which hedge funds don't, it shouldn’t be of a surprise that their popularity has and will continue to grow. So let's take a look at the four qualities.
Ease of Use and Open Access
Only "sophisticated" investors have access to hedge funds. The average Joe investor can't just call up a hedge fund and say please take my money and invest it for me. Typically only extreme high net worth individuals and other institutional investors have access to hedge funds. Furthermore, someone who does have access to hedge funds can't call up the fund on Monday and say I want I and then call the fund back up on Thursday and say they want out.
One the other hand, ETF's offer both access to all shapes and sizes of investors and not only allows investors the ability to trade in and out of funds on a weekly basis, but by as fast as a trade can be electronically performed. Day trading is in some cases, specifically leveraged ETF's, encouraged. The ability for the little guy to not only get into diversified investments outside their 401(k) plans is a true game changer, not to mention the fact that ETF's can be used by day-traders, which dramatically boosts their volumes and we are told their liquidity ( I personally am not so sure how much day-traders help liquidity within the markets).
Once an investors puts money into a hedge fund, the manager of that fund has nearly unlimited unrestricted freedom in where that money goes. The hedge fund can use those funds to become an activist investor in different companies or buy massive stakes in one form or another and essentially take control of the company and begin running the business the way they feel it should be managed. While there is nothing wrong with that form of investing, but the problem may be that you, the investors just want to invest in a wide range of companies and diversified your exposure. Furthermore, if the hedge fund has taken over a business and now running it, who is looking for new investment opportunities?
With ETF's we don’t see this. The ETF manager is simply a money manager, finding what they believe to be the best possible options based on the specific fund's investing restrictions. Yes, ETF's for the most part have restrictions on what they can invest in. For example an ETF that tracks the S&P 500, invests strictly in S&P 500 stocks. An ETF that follows gold, would invest in different gold stocks, perhaps the commodity itself or even gold futures, it all just depends on the restrictions the fund has set for itself. Those restrictions give investors better ideas of what they own, so there are not any surprises down the road.
The average hedge fund charges investors 2% of their investment and they take 20% of the profits made through investment activities. While the 20% is only added on if the hedge fund makes you money, even the initial 2% is a crazy large amount of money to charge each year.
The average ETF expense ratio is 0.31% or six and a half times less than the base fee the average hedge fund charges. Maybe you are thinking neither of those figures sounds like a lot of money. OK, let's break it down; 2% of $100,000 is $2,000 per year, 0.31% of $100,000 is just $310 per year.
So you think $1,700 is still not a crazy amount to pay for a hedge fund. Let's take a look at the 20% extra they charge on-top of gains. Let's say the $100,000 makes you a 10% return in both funds. In the ETF the full 10% goes to you and the manager takes his 0.31% fee, for a total cost to you of $310. In the hedge fund, you start with $110,000 after the 10% return, the manager then takes their 2% fee or $2,000 and then another $2,000 for the 20% of your gains for a total take of $4,000.
That means after one year with the ETF you have $109,690 compared to the hedge fund where your account balance would be just $106,000, after each fund essentially grew by 10%.
It would be one thing for investors to pay more money if they were getting better returns, but unfortunately they are not. In 2012 the HFRX or Equity Hedge Index which tracks the average hedge fund gained 4.8%, in 2013 it gained 11.1%, in 2014 it grew by 1.4% and from January to May 2015 it was up 3.4%. The largest ETF by assets, the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 index step by step, grew by 16% in 2012, 32.3% in 2013, 13.5% in 2014 and was up 2% from January to May.
Data courtesy of Forbes.com
While the average ETF performance is unlikely that high and while I am sure there are a few hedge funds that outperformed the SPY over the past few years, the fact of the matter is, they are more complicated to get into, cost more money and as the investor you have very little idea of what your owning when compared to something as simple as buying the SPY.
Small individual investors, and likely even the big boys, are better off with ETF's than hedge funds. And due to the increasing popularity of ETF's just based on their asset value, I would suspect the little investors will have even more to choose from in the future.
Disclosure: Matt Thalman did not hold positions in any company mentioned above at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.