Why ETFs Spell the End of Hedge Funds

by Nicholas Vardy
Yugo_Car

"All professions are conspiracies against the laity."

- George Bernard Shaw

I recently attended a presentation by the head of a prominent London hedge fund.

The meeting was held at a posh, members-only club in the tony Mayfair district of London.

Against this luxurious backdrop with old, hand-painted portraits lining the walls, this hedge fund manager bragged about the unique valuation metric that his team had developed to pick stocks.

I sat restlessly throughout the presentation, itching to ask him about growing competition from exchange-traded funds (ETFs).

When I finally got the chance, his answer was both derisive and arrogant...

With a wry smile, he dismissed ETFs as "simple toys" compared to his fund's complicated investment process.

He suggested that comparing hedge funds to ETFs was like comparing "a Porsche to a Yugo."

(The Yugo was the Eastern European export to the West that was the butt of jokes in the 1980s because of its ugly design and poor quality.)

In the past, I may have fallen for this pretentious nonsense.

But now, I saw a hedge fund manager who - to use George Bernard Shaw's words - was "conspiring against the laity."

Let me explain...

The hedge fund industry has been pulling the wool over investors' eyes for decades.

First, it wowed investors with secretive investment strategies.

Then, it convinced naive investors to dole out exorbitant fees to have their money managed by the "best and the brightest."

These fees made many hedge fund managers rich...

Even as the hedge fund industry lagged "buy and hold" index investing over the past decade.

To prove the point, in 2007, Warren Buffett bet $1 million that the S&P 500 would beat a basket of hedge fund strategies over 10 years.

In perhaps their most embarrassing moment... the hedge funds lost.

Today, investors see through the hedge fund charade because there's a new investment game in town...

The Hedge Fund vs. ETF Smackdown

Hedge fund managers bristle when investors compare them to ETFs.

Still, the uncomfortable comparison stands...

Like hedge funds, ETFs invest across a wide range of assets.

Hedge funds once had a monopoly on investing in commodities, currencies and exotic asset classes like Japanese small cap stocks.

Today, there are dozens of ETFs available for each of these investment themes - and many more.

Also like hedge funds, ETFs invest according to rigorously developed strategies... with one major difference...

Hedge funds' strategies are secretive and proprietary.

ETFs are transparent "smart beta" index funds that are weighted by any number of factors from "value" to "momentum" to "insider buying."

The one big difference between hedge funds and ETFs is the likeliest reason hedge fund managers bristle...

ETFs charge only a tiny fraction of the fees that hedge funds do.

The Hedge Fund Industry in Denial

Here's what the hedge fund industry can't accept...

First, its complicated investment strategies often lag the robust and straightforward strategies used by ETFs.

Second, the idea of the brilliant "cowboy" hedge fund managers offering outsized returns is a thing of the past.

Longtime London hedge manager Crispin Odey's fund was down 15% in 2017 while global markets were up 20%.

He wiped out all of his fund's gains since 2007.

Hugh Hendry, a former Odey protégé, had to shut down his hedge fund after trailing the market for a decade.

Even the venerable George Soros retired from managing money for clients in 2011.

No wonder hedge fund managers have lashed out against passive ETF-style investing.

Paul Singer, the founder of one of the world's biggest hedge funds, wrote that "Passive investing is in danger of devouring capitalism."

Another analyst called passive investing "worse than Marxism, given that communists at least tried to allocate capital efficiently."

What a load of bunk.

The only thing passive investing is in danger of devouring is Paul Singer's outsized paycheck.

Investors choosing better products at lower prices is what capitalism is all about.

The Canary in the Coal Mine

Smart beta ETF strategies have shed light on the dirty little secret of hedge fund investing...

Simple ETF strategies can match hedge fund returns at a fraction of the price.

Some major hedge funds have started to recognize this.

In July, London-based Aspect Capital - a quantitative hedge fund - launched an ETF to meet demand from clients.

J.P. Morgan launched two hedge fund index-tracking ETFs that cost only 0.57% to 0.67% of the underlying assets.

My predictions?

Growing investor appetite for ETFs will cause exorbitant hedge fund fees to collapse.

Ten years from now, ETFs will be triple the size of the hedge fund sector.

And many of today's hedge funds will transform into research labs for low-cost ETFs.

The difference between ETFs and the Yugo is that ETFs actually work really, really well.

And that's how the trading world's Yugo will ultimately overtake the Porsche.

Good investing,

Nicholas

Thoughts on this article? Leave a comment below.

It's Time to Get on the TEAM

In his 2017 annual letter to shareholders, Warren Buffett famously referred to active money (read: hedge fund) managers as "monkeys." The reason was the same as the one Nicholas asserts above: For individual investors, passive investing is superior to paying astronomical fees for returns that don't live up to overhyped expectations.

In fact, over the past decade, Buffett estimated that financial advisors made more than $100 billion - with a "b" - off the bank accounts of us regular folks in their futile attempts to "beat the market".

So why not save your dough and beat the hedgies at their own game? In his Momentum Alert update on February 20, Chief Investment Strategist Alexander Green talked about how institutional investors like hedge funds are driving up the price of Atlassian Corp. PLC (Nasdaq: TEAM) - and how you can get in on the action...

After a market correction like the one we had a few weeks ago, investors often look for bargains among the companies that have been beaten up the most.

That's a valid strategy for long-term value investors, but it's not necessarily the best approach for short-term traders.

They might be interested in stocks that dropped the least and bounced back the quickest. Why? Because that's a sign that shareholders didn't want to relinquish their holdings - and believe the company's business prospects are still exceptional.

A good example is Atlassian Corp. PLC (Nasdaq: TEAM).

Based in London, Atlassian is one of the world's fastest-growing software companies. Its specialty is project management and collaborative software that takes advantage of cloud-based technology and remote work spaces.

Atlassian is best known for Jira, the leading tool for software developers. It allows companies to plan, track and release their software by reporting real-world progress.

The cost? Just $7 per user or $10 for teams of up to 10 people.

You might reasonably question the advantage of offering a product that is so inexpensive.

Let's start with the obvious. No potential customer is priced out of the market.

The low price also obviates the need for a sales force. That's a huge factor since most software companies spend roughly half of their operating budget on sales and marketing.

Instead, the Atlassian customer simply and easily downloads the software and persuades the rest of his or her team to do the same, making the product viral thanks to its flexibility and user-friendly interface.

The firm already has more than 112,000 customers - including everyone from Domino's Pizza to Match Group to the U.S. Department of Defense - and annual revenue of more than $740 million.

The numbers are already superb. In the most recent quarter, for instance, earnings per share surged 44% on a 43% increase in sales.

Atlassian is also growing through acquisitions. Last year the company bought Trello - a firm that helps organize projects with visual boards - for $425 million. It was the company's 18th and biggest buyout yet.

I estimate that net income here will hit $0.49 a share this year and climb to more than $0.70 in 2019.

The cash waves of mutual funds, hedge funds, pensions and endowments are driving the stock higher. (It is up 76% over the last year.) Institutional investors already own 91% of the outstanding shares.

There is competition in this space to be sure. Microsoft and IBM are unhappy that Atlassian is eating their lunch. That's why the company itself - with a market cap of just $12.4 billion - is a prime takeover candidate.

In short, this is a company with massive sales and earnings growth, superb business prospects and exceptional short-term trading potential.

- Donna DiVenuto-Ball with Alexander Green

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