ETFs overtake hedge-funds, but there are side effects

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Hedge-funds have been around since the 1950s, as beautifully described in Sebastian Mallaby’s book “More Money Than God” (Bloomsbury, 2010). Exchange traded funds (ETFs) have been available since 1989, but despite being much later in the game, this investment category overtook hedge funds in assets under management (AUM). According to a recent report by CIO.com, AUM for global ETF’s reached a record high of nearly USD 3.0 trillion, compared to USD 2.97 trillion for hedge funds (also a record high).

We recently noted that investors continue to pour money into hedge-funds, despite a negative performance during the third quarter. However, the pace and size of inflows towards ETFs is much higher. During the first half of 2015, USD 125.3 billion went into ETFs, compared to ‘only’ USD 39.7 billion for hedge funds. This is quite remarkable, since 2015 isn’t exactly the best year for stocks or bonds. It leads no doubt that an passive strategy such as pursued by ETFs benefits from a bull market. But when uncertainty rises, investors move more towards ‘alternatives’, such as hedge funds, at least that is a common thought.

 

A much more plausible explanation is the continuing cost awareness of investors. In the past, when ETFs where still a niche, the hedge-funds’ 2-and-20 structure (2% annual fee, 20% performance fee) were less perceived as expensive. Mutual funds, which were the obvious choice for investors looking for a diversified product, were not much cheaper, also regarding potential performance. But with the investment industry becoming more and more focused on bringing down costs, for example a 0.1% expense ratio of SPDR S&P500 ETF (SPY) sounds like complete bargain, in particular during a bull market. Also investment advisors, wealth managers, smaller pension funds and other asset managers increasingly have to account for their costs. When picking a more expensive (mutual) fund over an index tracking ETF, the asset manager has to show an outperformance to be able to defend his/her choice towards the client.

The increasing size of AUM also drives larger asset managers, such as pension funds towards ETFs. In the past the liquidity of many ETFs (apart from the majors such as SPY, QQQ, IWM and EEM) was too small to warrant the investment size of pension funds. With investment mandates of hundreds of millions and even billions USD, entering and exiting ETFs could influence the market. In particular in times of market turmoil, this could lead to mispricing in the market, as we earlier reported. Only a few ETFs were worthy to be considered in the past, but with continuing growth in many ETFs, this group becomes larger and larger.

But there is another important side effect of large investors and pension funds moving into ETFs: investing may become too passive. When buying individual shares of a company, a pension fund obtains shareholder rights such as voting rights at the General Meeting of Shareholders. As such, the investor could press the managing board in certain decisions. In a time where there’s a sharp increase in focus on environmental, social and governance (ESG) policies, giving away voting rights is unwanted. Pension funds are held accountable by their participants for their position in these matters. With no voting power, they are not acting in the best interests of their participants. Therefore, investing in ETFs by asset managers with a certain social accountability should move beyond simple cost-based decisions. Although non-monetary, passive investing comes with a price, too.

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