Hedge funds have been struggling recently. According to CNBC, hedge fund outflows reached $60 billion in June, with the rate of withdrawals increasing. Although the average American might not feel much sympathy for the typical hedge fund manager, the struggling hedge fund industry points to a real problem in the financial sector: the Federal Reserve’s suppression of overall volatility and the corresponding suppression of inter-asset volatility. When overall volatility (in the sense of the S&P moving up or down) is suppressed, inter-asset differentiation is also suppressed.

This should make intuitive sense – if there is a giant influx of new credit, all asset prices go up and so the relative change in price is attenuated. The relative change in price between different assets (hereafter referred to as inter-asset differentiation or inter-asset volatility) is also therefore less. The current popularity of index funds and the corresponding contemporary distaste for hedge funds both reflect this point.

Basically, because newly-printed money has to go somewhere, it distinguishes less between assets (compared to what it would have relative to the old price). By inflating assets prices basically all across the board, central bank easing has dulled the market’s price discovery mechanism.

Warren Buffet’s famous quote “Only when the tide goes out do you discover who’s been swimming naked” reflects this point well –when there is an influx of credit the markets perception of corporate value is distorted and its ability to differentiate is dulled – only when the credit cycle reverses does the market regain its ability to differentiate. When the “tide goes out” there is credit scarcity and the opposite logic applies: volatility and inter-asset differentiation spike.

Think of this effect mathematically: consider asset A and the universe of stocks with which it is compared. Both appreciate at an extra 1 percent a day because of a new influx of credit. This example expresses the process of credit expansion: since the influx of new money is gradual, valuations increase not automatically but over time as credit expansion settles its way into the market.

Theoretically, therefore, the best representation of undiscriminating credit inflows is a smooth curve. The hypothetical 1 percent move is a first derivative of that curve and can be applied to any timeframe, as long as it is continuous. The same theory can also be generalized to illustrate the entire process of credit expansion, no matter what the actual rate of that expansion is. On a day in which an asset A would have declined by 1 percent and the index risen by the same rate, asset A would now not move and the index would increase by 2 percent. Asset A’s performance is now more similar to the market’s.

The same effect happens even if the numbers are different: if asset A appreciates 2 percent and the market 3 percent, now it would be 3 percent and 4 percent, and instead of moving two-thirds of what the market moved it now would move three-fourths. The result is that the stock tracks the market more closely, and the distribution of betas is compressed. For a hypothetical market with a normal distribution of returns, graphically the effect looks like this:


Note that the overall market returns have increased, and that the distribution of betas has compressed. Returns, while increasing, cluster more closely around the market average.

A further point is that the mechanism is self-reinforcing: because assets are rising in price, the perception of relative risk (Beta, Sharpe ratio, etc.) diminishes and newly-created money is therefore more likely to flow to those artificially less risky assets, further diminishing their perceived risk and further degrading the market’s ability to differentiate.

The result is that inter-asset volatility goes down further. This effect is particularly pronounced with risk metrics like the Sharpe ratio that give greater weight to negative movements than positive ones. Across the board credit expansion impacts these ratios more severely because the relative reduction in negative movements is larger compared to the increase in positive ones. For example, a shift from 1.5 percent to -.5 percent is a much larger relative change than 1.5 percent to 2.5 percent.

Index funds are both a reflection of and reason for this trend. Index funds do not distinguish between different stocks in an index when they buy stocks – they buy a little bit of each company proportional to its size. The same logic applies as with credit expansion above: such indiscriminate buying compresses the beta distribution of all the stocks within an index. Index funds are also more profitable if inter-stock volatility is down because it is less profitable to distinguish between stocks.

What does this mean for portfolio allocations? The implication of the argument is that the market cannot distinguish as well between risky and non-risky assets during credit expansions. Therefore, returns during expansions are not as accurately risk-adjusted and so absolute returns are more similar across disparate-risk assets. Risk has been mispriced and over-bid. One should therefore decrease risk in one’s portfolio and buy assets that perform especially well when the “tide goes out.” Because of the smaller performance difference between disparate-risk assets, this should not affect returns as much if the expansion continues.

One might also want to rebalance the portfolio to include more cash, precious metals, and corporate securities with very strong balance sheets. These assets are mostly ones that perform well during periods of high overall volatility. When the market underperforms and investors rush to reduce their exposure to risk, these assets will appreciate in relative terms and perhaps even relative to cash (e.g. gold). If credit expansion continues, portfolios should not be affected as much because the rising tide will still “lift all boats” and less-risky assets should be among that tide. In any case, to paraphrase Warren Buffet, don’t get caught swimming naked when the tide goes out.

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.