Why ETFs Spell the End of Hedge Funds
"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.
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.
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