Is Yesterday’s Hedge Fund Strategy in Tomorrow’s ETF?

By 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.