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.