07/22/15   ETFs vs. Hedge Funds

Editor’s Corner

Ron Rowland

ETFs and hedge funds found themselves mentioned in the same sentence this week – and it happened more than once. The first was a report issued by London-based ETFGI stating that global assets in ETFs have surpassed hedge fund assets for the first time. The second was an article in this morning’s Wall Street Journal revealing that hedge funds are gearing up to profit from the perceived imminent demise of various alternative and bond ETFs. Coincidence? Maybe not.

Hedge funds have been around for decades. These private partnerships are notorious for making outsized bets, usually unhedged ones, and charging exorbitant fees to those lucky enough to get access. Historically, the standard fee structure on these vehicles was 2% of assets annually plus 20% of the profits. Hedge funds that only owned other hedge funds (funds-of-funds) were a means for more investors to get access, adding yet another layer of fees. Still, there always seemed to be at least one fund able to rack up a spectacular performance number in any given year despite the fee structure. Much like lottery players looking for the big payoff, money came flowing in with the hope of a huge return.

Then, ETFs came along, offering investors market exposure with lower fees. Since most early ETFs tracked established indexes, hedge funds didn’t consider them to be a threat. Then, newer ETFs started offering strategies similar to hedge funds, and today there are many hedge-fund-replication ETFs available. The performance of this new breed of ETFs has not been great, but then again, the average annual returns for popular hedge fund indexes have not been great either. Whether or not these new ETFs are meeting their objectives, they are attracting new assets. Meanwhile, asset growth for hedge funds has stalled, perhaps due to competition from ETFs.

According to the ETFGI report, the 22-year-old global ETF industry now has $2.97 trillion in assets, slightly surpassing the amount held by the 66-year-old hedge fund industry. The firm states that evidence of investors selling their hedge funds to buy ETFs is lacking. However, the growth differences are probably due to the perceived cost effectiveness of ETFs combined with the failure of hedge funds to deliver on their promise of providing higher alpha.

A small handful of hedge funds made huge gains during the housing market collapse. Now, hedge funds are lining up bets that the ETF market is next to collapse. The investment theory goes like this: just like the easy credit lured unsuspecting retail home buyers into an overpriced housing market, the easy access of ETFs is luring unsuspecting retail investors into emerging market debt and other less-liquid market segments. In other words, hedge funds are making bets against their new competitors – ETFs (and ETF investors).

There are potential market scenarios that might prove the hedge funds wrong, and there are scenarios where they will probably be correct. As an ETF investor, you need to keep yourself out of the cross hairs of this battle. As always: understand and limit your exposure; have a sell plan before you buy; monitor your positions; and follow your plan.

Investor Heat Map: 7/22/15

Sectors

Health Care tops the sector rankings for the tenth consecutive week. It has also expanded its margin over the other sectors since last week. Financials jumped from fourth to second as bank earnings produced mostly favorable stock action. The rise of Financials pushed Consumer Discretionary and Consumer Staples each one step lower. Technology turned in the best performance of any sector this past week, although it did not result in a relative ranking improvement. However, the gains boosted momentum for Technology from a negative reading to a double-digit positive score. Six sectors are still in the red and are still in the same relative order as a week ago. Real Estate, Utilities, Telecom, and Industrials all treaded water this past week, while Materials and Energy fell deeper into the red. Materials dropped hard as mining operators and chemical producers came under selling pressure. Energy was the only sector more pathetic than Materials over the past week, securing its last-place position.

Styles

Small-Cap Growth has been at or near the top of the style rankings for most of 2015. This week, it relinquished the top-ranked spot while still maintaining its role as a leader. It fell to third, but a visual examination of the ranking chart indicates it is one of three style categories clearly above the crowd. Mega-Cap is the new top-ranked style, jumping up from fifth. Large-Cap Growth followed in its footsteps, climbing from fourth to second. The outsized moves by Mega-Cap, coupled with the relative weakness in Micro-Cap, left the style rankings in a convoluted state. The capitalization extremes of Mega-Cap and Micro-Cap are both located within the top-five slots. Large-Cap Growth and Small-Cap Growth find themselves side-by-side in this upper tier also. It is too early to determine if this is the start of a major leadership change or just another mid-course correction. Four categories remain in the red, and they are the same ones as last week. These laggards consist of the three Value categories plus Mid-Cap Blend.

Global

The Eurozone climbed to the top after encountering a near-disaster a few weeks ago. This category is likely to be further buffeted by the ongoing Greek crisis, but for now its relief bounce has been strong enough to earn it the top spot among the global categories. Its jump pushed the US down to second even though the US posted a momentum increase for the week. Japan held steady in third after relinquishing its first-place honor to the US a week ago. EAFE, the UK, and World Equity all held their middle-ground rankings while flipping from red to green. The lower tier underwent a rearrangement, but the constituents are still a sorry lot. Pacific ex-Japan and Emerging Markets both climbed a notch and pushed Latin America two spots lower in the process. As bad as things have been for Chinese stocks lately, it may be surprising to see the China category climb a notch higher in the rankings. Canada may seem out of place on the bottom, but since its economy is largely dependent on the currently weak Energy and Materials sectors, its new position is justified.


Note:
The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.

 


“They are going to be toast.” 

David Tawil, president of the Maglan Capital hedge fund.

“A lot of questions come from a fundamental misunderstanding of ETF mechanics.”  

Matthew Tucker, managing director at BlackRock (iShares ETFs)


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