Exchange traded funds have done a lot for not just retail investors, but all investors of every shape and size. They have done a very good job of highlighting the impact fees have on long-term returns while also driving actual fees across markets down to more competitive levels. They have also provided investors an easy way to gain access to pretty much any market out there, and as we highlighted recently in the ETF Update*, they are now starting to move into more active investment strategies. To be clear, ETFs have been ‘active’ for some time now with factor tilts, option strategies and smart beta beginning to proliferate but have managed to maintain the passive, long-term affiliation so often attributed to the investment vehicles (for better or worse). However, with ETFs such as the BMO Put/Write, Horizons Sector Rotation and even market neutral ETFs, these funds are moving more and more down the risk spectrum and into truly active or alpha-seeking areas of the investment universe. So where does this leave Hedge Funds?

To be clear, we are believers in active investing and think that in a worst case scenario, it is an important part in price discovery and that investors CAN beat the markets by going it alone, if not just by saving the fees, but the necessary time and effort is required here. If an investor is not willing to put some time into understanding some of the basics about investing, ETFs are probably the way to go in most cases, or using an advisor. What we are not believers in are high fees, and the longer both mutual funds and hedge funds maintain high cost structures, the longer ETFs will have to add unique products with alternative strategy exposures, steal market share and the more assets will bleed out of higher cost funds.  The cost argument against hedge funds is well known, and Warren Buffett has recently highlighted it once again at the Berkshire Hathaway annual meeting but the cost side of the story is only half of it when looking at the potential behind ETFs to eat the lunch of hedge funds. The other side is access. Regardless of how much hedge funds are hated in the media, the siren song will always exist and as ETFs begin to replicate every ‘passive’ strategy out there, it is not a stretch to think that they will reach into more unique strategies over time and this is where hedge funds are at risk. They shouldn’t be concerned about the Vanguard S&P 500 ETF (unless they consistently underperform it!) but they should be very concerned by the ‘Insert ETF Co. name market neutral fund, Long CAD/Short USD fund, etc.’ that will be on their way if not already. As investors gain more and more access to these types of unique strategies at a low cost, it will be all the more difficult for retail, accredited, and institutional investors to justify 2 and 20 fee schemes. Why pay a manger to give you exposure to a specific bet on ‘long India Equity, short US bonds’ when you can buy it yourself in ETF form and adjust the weighting yourself, in a way that is more appropriate for the specific investor?

Macro Hedge Funds at most risk?

For full disclosure, while aside from fees we do not have much against hedge funds, we are not big believers in macro hedge funds (funds that make calls on large/broad economic or demographic trends). Investing on an exchange rate, GDP growth, demographic trends or whatever, seems to be a fools errand at times when aspects far out of any ones control such as war, politics, sentiment, interest rate movements, you name it, can blow up a macro thesis. This is why we far prefer a company-specific, bottom up approach. While these types of events will also affect individual companies, the companies have an ability to insulate themselves from the impact by improving margins, cutting costs and having strong balance sheets among other things and sometimes can still outperform a market that is on a broad decline. 

This is where we think active ETFs will have the most success against hedge funds, in the macro arena. Given the number of ETFs that exist already, it is not hard to imagine an investor being able to choose five or ten different ‘macro ETF theses’ compared to an investor that is usually locked into one or two hedge funds with a specific view, style or strategy. If ETFs begin to stretch into this space, they will offer lower costs, more options, better diversification opportunities across these options, and (maybe) better liquidity. When an investor overlays how hard it is to be a macro investor (in our opinion) to begin with; a diversified ‘hedge fund ETF’ strategy becomes all the more attractive.  What will be difficult for ETFs to emulate is old-fashioned stock picking. ETFs are good at finding factors that have outperformed and at providing access to these styles or tilts but often times good investments are the growth stocks that actually look like ‘value’ and are less likely to be caught by an ETF. Exchange traded funds will also have less of an ability to weight specific securities in any logical way compared to a bottom up hedge fund. One may say this same argument applies to macro funds but due to the number of potential ‘macro bets’ out there versus individual stock combinations out there, it should be easier to create a macro hedge fund buffet of offerings than a stock specific hedge fund replacement.

Where do we go from here?

Taking this thought process to the extreme, ETFs crowding out active funds could be a bad thing for price discovery but there is probably a lot of money to be made regardless of whether a manager gets 2% and a performance fee or just a ~1% management fee. One could even argue that if more investors can gain access to these types of active ETFs, the total market as measured by assets could actually become bigger for these types of funds, but also a lot more competitive. Regardless we think two things are for certain, fees will continue to fall and ETFs will continue to take market share over the long-term, how the competitors of exchange traded funds will adapt (if at all) is up for debate. 

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