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Talking Points:

  • Disappointing returns for Hedge Funds have resulted in asset outflows recently
  • Investors are instead pumping money into passively managed index ETFs
  • How the two investments compare in structure and performance

Hedge Funds have been taking a beating lately and just recorded one of the worst quarters of performance in 3 years. Performance is lagging with a year to date return of 1.7 percent on the HFRI asset-weighted index as of September 30, compared to a 4.4 percent return over the same period a year prior. Investors have responded by pulling their money out of the Hedge Fund space and redistributing capital to other assets with more alluring rates of return.

One of the most popular investment vehicles traders have turned to are passively managed index ETFs (Exchange Traded Funds) such as the SPDR S&P500 ETF – but why? Passive index investments like the SPY differ from Hedge Funds on 4 major fronts: access, fees, strategy and performance.

Access: Hedge Funds are available only to accredited investors. Investors satisfy the accreditation requirement by either earning $200,000 in annual income or have a net worth exceeding $1,000,000. ETFs are available to nearly any investor with a brokerage account, IRA, or 401(k) plan making them much more accessible. Liquidity restrictions on Hedge Funds is a feature that limits access to one’s investment seeing that long lockup periods, sometimes up to several years, prohibit investors from selling their investment until a specified amount of time has passed. This is contrary to ETFs where investors can buy and sell a position seamlessly and access their funds usually within a couple business days.

Fees: The ultra-low fee structure of ETFs has been a major driver of its popularity among investors. Average expense ratios on index ETFs run around 0.3 percent not to mention Fidelity recently announcing an index fund with an unprecedented zero expense ratio. The cheap passive funds make it difficult for Hedge Funds to compete as the latter’s fee structure follows its industry standard of a 2 percent annual fee for managed cash in addition to its whopping 20 percent performance fee levied on returns.

Strategy: The main differentiating factor between Hedge Funds and ETFs is the polarization of active versus passive management of investments. Hedge Funds, which take an active approach, have formed several investment strategies spanning long-short, pure-quant and “fund of funds” methodologies among others. Portfolio managers of Hedge Funds generally have unrestricted discretion over the types of investments they can make so long as those decisions made are within the confinements of the fund’s strategy laid out in its prospectus. On the other hand, index ETFs are passive investments that follow a “hands-off” approach aiming to track its underlying benchmark in lockstep.

Performance: The difference in performance between Hedge Funds and index ETFs begins with the return objectives for the two types of investments - Hedge Funds attempt to generate the highest return in excess of its benchmark while index ETFs aim to match its benchmark returns 1 for 1. Performance varies drastically across the two asset classes considering the wide spectrum of indexed ETF offerings like sector specific plays. As for Hedge Funds, the best performing portfolios tend to keep performing well under oversight by the world’s top managers. Returns from the top performers stand out exceptionally relative to the bottom distribution of Hedge Funds which drags down the average return for the broad universe of active management. However, it is crucial to point out that absolute return measures do not provide the full picture when comparing performance between investments.

Performance Price Chart of the HFRI Asset-Weighted Index versus SPDR S&P500 Index ETF:

Hedge Fund Performance Falters as Investors Flock to Passive Strategies

The bull market recovery following the most recent financial crisis has enjoyed a slow and steady ascent since the recession. The appreciation in equities conjoined with headlines stating passive investment strategies outperform active ones contributed to the boom in index ETFs over recent years. A driving factor of this is the premise that index ETFs are straight bets that stocks will continue moving up. On the other hand, Hedge Funds offset (or hedge, hence its name) positions by taking a neutral stance enabling profit opportunities regardless of the market going up or down. Although hedging provides downside protection to investors, it comes at a cost and thus eats into the investment’s returns especially when the market is steadily advancing. This has contributed to the current capital re-distribution from Hedge Funds to index ETFs.

However, as Sir Isaac Newton once said, “what goes up must come down”. The stock market is not immune to the laws of financial value which closely follows those of physics in this regard. In other words, equities cannot continue to climb forever. So how does the performance of the two investment vehicles compare when the market turns sour?

Price Chart of Hedge Fund Returns when the S&P500 is Negative:

Hedge Fund Performance Falters as Investors Flock to Passive Strategies

A different outcome emerges when comparing performance between index ETFs and Hedge Funds over periods when the stock market is experiencing a downturn. This relates to the point previously mentioned that absolute return measures viewed in isolation do not provide the full picture when comparing performance. A superior metric for analyzing investment returns is the Sharpe ratio. Calculated by dividing an investment’s return in excess of the risk-free rate by its standard deviation of returns, the Sharpe ratio measures an investment’s performance in consideration of the amount of volatility, or risk, the investment exhibits.

This allows investors to look at different investments on a level playing field as it standardizes the returns for a given level of risk assumed. In other words, the Sharpe ratio is an “apples to apples” comparison of investment performance with a higher Sharpe ratio yielding a superior investment. See the table below for Hedge Fund, S&P500, and Barclay’s Aggregate Bond Index Sharpe ratios over different time periods.

Hedge Fund Performance Falters as Investors Flock to Passive Strategies

While recent absolute return measures may indicate that the S&P500 has been a better investment, the Sharpe ratio clearly indicates otherwise. Hedge Funds have consistently outperformed major stock and bond indices on a risk-adjusted basis over several timeframes. This is attributable to the investment strategy employed by Hedge Funds limiting downside risk. Since 1990, the S&P500 outperformed Hedge Funds only 3 times out of the 37 instances that the S&P500 was lower over a given quarter. To elaborate this point further, October 2018 was a woeful month for global asset classes. The S&P500 lost nearly 7 percent of its value, but the professionally managed Hedge Funds earned more palatable declines of 2.35 percent over the same period.

A Lurking Risk to Global Markets Should ETFs Come Under Pressure

Another important theme worth mentioning is the contagion risk inherent in ETFs that could materialize during large market selloffs. As ETFs are bound by their allocation weights to the benchmark index constituents, pullbacks in the market can snowball as the fund is forced to liquidate collateral and rebalance position weights. This in turn induces additional selling of the fund’s constituents. Furthermore, ETFs inflict more pain to markets under downward pressure as they discourage price discovery since passive investors are “buying the basket” instead of making an investment based on a security’s true intrinsic value. Ultimately, these overcrowded ETF trades induce a “snowball” effect on sentiment as excess selling leads to panic and more selling. This could result in a doomsday-like scenario under extremely volatile conditions when the next bear market or recession hits. In such an environment, investors who have a pure-long position in index ETFs will likely suffer more significant losses while Hedge Funds can perform better – even if that is in the form of less severe losses.

To see what DailyFX is projecting for stocks, check out our Equities Forecast here.

--Written by Rich Dvorak, Junior Analyst for DailyFX.com

--Follow on Twitter @RichDvorakFX