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Why Are ETFs Beating Hedge Funds on Assets & Returns?

Sanghamitra Saha

By now, the ETF Industry’s exponential growth is known to all. The industry has gained immense popularity within just over 20 years. There are close to 2,050 U.S.-listed ETFs to date with $3.06 trillion in assets. Not only this, a considerable number of ETFs are in the pipeline, pointing to growing investor interest for exchange-traded products in this market (read: 6 Successful ETF Launches of 2016).

Consulting firm ETFGI reported that assets invested in global ETFs/ETPs touched a new record of $4.168 trillion at the end of first half of 2017. There were at least 6,965 ETFs/ETPs from 328 providers listed on 70 exchanges in 56 countries (read: Too Many ETFs Flying in the Market?).

The popularity led ETFs to garner $1 trillion more investor assets than hedge funds globally for the first time ever at the end of June, according to ETFGI. Assets in ETFs first topped hedge funds two years ago, and has maintained the momentum since then.

During 2016, globally listed ETFs/ETPs amassed a record $389.4 billion of net inflows, superseding the prior record of $372.3 billion gathered in 2015. By the end of December 2016, ETFs/ETPs had registered 35 successive months of net inflows. On the other hand, hedge fund investors pulled out $70.1 billion, the largest annual outflow since 2009, when $131.0 billion was extracted, according to ETFGI.

In the first half of this year, ETFs around the world attracted a net $347.7 billion in net new assets, according to ETFGI, while hedge funds drew a net $1.2 billion, according to HFR, going by an article published on barrons.com.

Let’s find out the reason behind ETFs’ upper hand over hedge funds.

Higher Returns in ETFs Than Hedge Funds

Hedge funds are privately owned companies that invest investors' money into several complicated and exotic financial instruments with a motive to outperform the market, by a wide margin. But in reality, hedge funds underperformed the market in recent times.

The below-mentioned source indicates that returns from the S&P 500 have consistently outperformed hedge funds since 2011. This piece of information is strong enough to drive investors toward ETFs and shy away from hedge funds.


ETF Fees Lower Than Hedge Funds

As per an article published on Investopedia, “the standard management fees charged by hedge funds, including a common 2% annual management fee and as much as 20% of the profits over a certain hurdle rate” appear costlier than what an ETF charges. Hedge funds’ active management leads to this higher cost.

Average expense ratio of U.S.-listed ETFs is 0.59%, with many popular ETFs like Schwab U.S. Broad Market ETF SCHB, Vanguard Total Stock Market ETF VTI andiShares Core S&P 500 ETF IVV charging as low as 0.3% to 0.4% (read:Will Low Cost ETF Strength Make Vanguard Top Asset Manager Soon?)

So far, the lowest cost corner was ruled by Charles Schwab and Vanguard. But the price war among issuers aggravated lately with competition on the rise. Other players like BlackRock are also resorting to the fee cut route to grab market share (read: Strong ETF Inflows Boost BlackRock Earnings).

ETFs Are More Regulated Than Hedge Funds

Though Hedge funds with assets under management over of $100 million are required to register with the U.S. Securities and Exchange Commission (SEC). However, a hedge fund advisor may evade registration with the SEC if he qualifies for the private fund advisor exemption under the Dodd-Frank Act, as per Investopedia.

On the other hand, ETFs are much more regulated. With the Department of Labor (DoL) fiduciary rule – which requires financial advisors to work in the “best interest” of their clients when selling retirement products – taking effect earlier this year – things are likely to become more lucrative for ETF investing (read: How Retirement Saving Rules are Making ETFs More Attractive).

ETF Investors’ Coverage Wider than Hedge Funds           

While ETFs have attracted retail investors mainly along with institutional investors like sovereign wealth funds, university endowments and professional asset managers, hedge funds’ clientele mainly concentrates on HNIs. As a result, in the period of underperformance, the clientele coverage of hedge funds gets reduced.

In fact, the hedge fund industry has lately been targeting ETFs’ success to generate their own returns. Around 92% of senior hedge fund professionals expect an increased usage of ETFs within their industry this year.

Hedge Fund ETFs

Still investors having an inclination for hedge funds may reach that segments by targeting hedge fund ETFs. This way investors can easily beat the beleaguered investing zone. Below we highlight a few ETFs that have returned 8% to 16% this year.

AlphaClone Alternative Alpha ETF ALFA – Up 16.7%

The underlying index of the fund – AlphaClone Hedge Fund Downside Hedged Index – tracks the performance of U.S.-traded equity securities to which hedge funds and institutional investors have disclosed significant exposure. The fund charges 95 bps in fees.

Aptus Behavioral Momentum ETF BEMO – Up 9.1%

The Aptus Behavioral Momentum Index tracks the performance of 25 large US-traded equity securities. It quantitatively ranks large U.S. companies based on a combination of momentum and irrational investor behavior and seeks to gain exposure to only the highest-ranked stocks. It charges 79 bps in fees.

IQ Hedge Long/Short Tracker ETF QLS – Up 8.4%

The IQ Hedge Long/Short Index seeks to replicate the collective hedge funds pursuing a long/short strategy. It charges 75 bps in fees.

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