Is Yesterday’s Hedge Fund Strategy in Tomorrow’s ETFBy John Lunt, President, Lunt Capital Management, Inc.

I was recently part of a conversation with a group investment industry professionals. The discussion was wide-ranging, covering industry trends, fee compression, and the performance of various investment strategies.

The conversation was spirited, with multiple points of view and strong opinions. In the midst of the conversation, someone made the comment, “I would not want to be in the hedge fund industry right now.” Everyone in our discussion seemed to agree. What a stark contrast from 10 years ago, when everyone wanted to be in the hedge fund industry!

Mark Twain once made the comment, “The reports of my death are greatly exaggerated.” I believe this comment applies to the hedge fund industry. Investors will always pay for skill and talent, of which there is an abundance in the hedge fund industry. However, there is a meaningful portion of the hedge fund industry that has died over the past decade at the hands of ETFs and ETF strategies. The reasons behind this titanic shift towards ETFs is worth exploring, and it provides context for the passive vs. active management debate.

The term “hedge fund” is one of the great misnomers in the investment world. While some hedge funds actually hedge, there are many that do not. The term “hedge fund” gives little insight into the strategy or investments associated with the fund—in reality, the thing that hedge funds have most in common is a fee structure. Hedge fund fees vary, but hedge funds are stereotypically known for a “2 & 20” fee structure—a 2% management fee and a 20% performance fee. In addition, many hedge funds avoid providing transparency to their investors and will only provide liquidity on a set schedule—monthly, quarterly, or annually. They may have the discretion to put up a “gate” that limits this liquidity. Hedge funds typically require high minimum investments, making them exclusive to institutions or high net worth investors.

Why would many smart, sophisticated investors pay these high fees and agree to the accompanying restrictive terms? The answer in one word is access. Investors would pay “2 & 20” to gain access to additional asset classes or sub-categories of investments (exotic beta) or they would pay to gain access to unique strategies that enhance the risk/return profile of their portfolios. Investors would pay for access to hedge funds that offered valuable attributes, such as lower volatility, lower correlation, downside protection, or that generated outperformance.

Fast forward through the explosive growth of ETFs and ETF strategies over the past decade. ETFs offer transparency down to the specific allocation and holdings. Most ETFs provide transparency in methodology. ETF fees are so low they are talked about in basis points rather than in percentages. ETFs are traded on an exchange, so there are no lockups and no gates. When you add these attributes to the tax-efficiency and the lack of minimums, the argument for ETFs is compelling.

The growth of ETFs has resulted in efficient and cost effective access to most of the exchange-traded investment universe, including segments of this universe that used to be termed “exotic beta.” Investors simply do not need to pay “2 & 20” for beta exposure. If the “value add” for a particular hedge fund relied on providing beta exposure, whether that was exotic beta ranging from India Small Cap Stocks to Bank Loans, that hedge fund likely cannot survive. Hedge funds reveal the challenge of active mutual fund managers—investors will no longer pay high fees to access the market.

Hedge funds could justify “2 & 20” by offering unique strategies with valuable portfolio attributes. These strategies are sought after, as “strategy” will have a different profile and attributes than market exposure or “beta.” Make no mistake, there are many talented hedge fund managers that more than justify their fees. However, some of the favorite hedge fund (and active mutual fund) strategies are now available within ETFs. Factor investing (low volatility, deep value, high quality, and momentum to name a few) have been some of the favorite hunting grounds for hedge funds and active mutual fund managers. The smartest thing about smart beta, is that it took expensive beta from hedge funds and active managers and transformed it into inexpensive beta within ETFs.

Not only are there now hedge fund strategies within ETFs, but there is also a proliferation of hedge fund-like strategies using ETFs. Specifically, ETF strategists and managers are building ETF portfolios that include tactical rotation, deliberate overweights and underweights, and even the ability to “hedge” by moving to cash or to inverse positions. In many cases, these ETF strategies provide the type of exposure investors had hoped to access through hedge funds—lower volatility, downside protection, lower correlation, or return generation—at a fraction of the cost! ETFs have allowed an investor of any size (including hedge funds, active mutual funds, ETF strategists, and individual investors) to complete in the new arena of active management—attempting to add alpha through the tactical allocation of beta. The “new active” using ETFs involves making decisions about factors, sectors, or asset class tilts. In fact, the next generation of ETFs are packaging strategic or tactical combinations of ETFs within a single ETF. These could be considered hedge fund-like strategies with liquidity, transparency, and low costs.

Where will we see hedge funds flourish? In areas with high barriers to entry, low liquidity, or constrained capacity. Make no mistake—there will always be room for skilled hedge fund managers in the “zero-sum” world of investment alpha. However, ETF managers are capturing some of that alpha for a handful of basis points rather than for “2 & 20.” Thoughtful asset allocators are refusing to pay up for pure investment beta exposure, even in previously hard to reach corners of the market. The rise of ETFs and ETF strategies is a win for all investors, with the exception of some expensive and disappointed hedge fund managers.

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