Lessons Learned From the Rise of ETFs

For a large part of the 1980’s, 1990’s and the early 2000’s, hedge funds were equated with enormous financial success. Serving as investment vehicles primarily marketed towards the wealthy, hedge funds use a plethora of aggressive investing strategies in an effort to generate outsized returns. These strategies worked very well for the funds and for their clients for a short while. Yet, as the Securities and Exchange Commission (SEC) began to change the rules and monitor the actions of these funds more closely, the hedge fund game changed forever.

In 2004, hedge fund managers were required to register their operation formally with the SEC and tie their name to that of their firm. This was mainly intended to keep portfolio managers accountable as fiduciaries. Then, after the global financial crisis in 2008, lawmakers in Washington D.C. took more decisive action to protect domestic financial markets. The Dodd-Frank Wall Street Reform Act of 2010 passed and brought with it more significant regulations to the United States’ financial sector. The restrictions on hedge funds were far more severe than what happened in 2004, such as extensive screening of investors and the presentation of sensitive data on trading positions. Because of the more stringent regulations, the risks that hedge funds once were able to take became almost impossible. Most notably, the Volcker rule has been placed into effect, which placed higher restrictions on speculative investments and proprietary trading that do not benefit the customers of funds.

The success of the exchange-traded-fund (ETF) blossomed. ETFs are low-cost funds that track market indexes, asset classes, or commodities and are publicly traded like stocks. There is a stunning cost difference between ETFs and hedge funds. Hedge funds require a significant amount of active management and they usually charge a two percent annual management fee and a 20 percent fee on all profits (aka “two and twenty”). ETFs, however, charge anywhere between less than one and six percent on the basket of securities. Additionally, ETFs have the potential to attract the same clientele that hedge funds have traditionally won over: high net worth individuals. With high tax efficiency and low fees, ETFs are a no-brainer for high net worth portfolios.

Understanding their advantageously low costs and taking into account the massive losses hedge funds incurred during the crisis, ETFs became a very desirable investment vehicle. Following 2008, total account balances in ETFs grew at an exponential rate and have continued to grow at an enormous annual rate of around fifteen percent compared to that of hedge funds’ annual rate of around nine percent. This past summer marked a big milestone for ETFs because total account balances for ETFs over took total account balances for hedge funds.

Assets under management (The Economist)
Assets under management (The Economist)

What this highlights above all is a shift in demand from active to passive investment management. In recent years, active investment managers have seen large fluctuations in their ability to beat passive funds. Ben Johnson, Morningstar’s director of global exchange-traded-fund research notes that “more than anything, fees matter” when seeking compounded capital gains.

The theoretical debate on whether passive or active investing is truly more advantageous in the long run has been going on for quite some time at this point. First, we must discuss Modern Portfolio Theory (MPT). MPT dictates that investment diversification should play a complimentary role. Indeed, each investment in a given portfolio should play off the successes or failures of other investments to maximize return. MPT teaches us that there is a possible combination of assets that assumes very little risk and comparatively large return. This is all well and good, but one of the main assumptions of MPT is information efficiency and that is where the theory gets tricky. Given efficient markets, then all known factors will be priced into different stocks making it nearly impossible to beat the market in any case. Information asymmetry, the exact opposite as information efficiency, is actually the case, the effort, let alone the capital, necessary to achieve the proper asset diversification that mitigates a significant amount of risk and generates sizable returns.

With the facets of MPT in mind, we can now begin to weigh in on active and passive investing aspects. Active investors assume more financial risk when trying to beat market indices, but passive investors take a significantly lower amount of risk when riding along with the successes or downfalls of markets. While the difference in returns of these two investing styles can be enormous, it is often enough that active investors, in fact, find themselves unable to generate returns that properly justify their assumed risk.

Active vs Passive Performance (Forbes)
Active vs passive performance (Forbes)

What is so specifically important about the ETF versus hedge fund account balance trend is that when it comes to assuming financial risks, most investors don’t seem to really want to make double-digit returns when it means that their losses could be of equal magnitude. Kenneth French, Finance Professor at the Tuck School of Business at Dartmouth College, has commented extensively on the chance of investors doing better than indices. Indeed, Professor French’s Efficient Market Hypothesis (EMH) postulates that in the indefinite long run it is impossible to beat the market without acquiring high-risk investments. It would appear that the people are beginning, more so, to agree. Even if beating the market is possible in the short run, it takes effort. Stretching that effort into the long run and observing that beating the market is nearly impossible, it would seem that the effort is not worth it.

ETFs are here to stay for the long-term. As more people want to find a cost and effort-effective way to participate in the markets and gather sizable returns, the more popular ETFs will continue to grow.