The price of performance

Although exchange-traded funds (ETFs) have been around for a quarter century, they’ve really taken off over the last five years, pulling in new assets every quarter at an exponential rate.

At the end of June, ETFs hit yet another new milestone: assets in the global ETF industry surpassed assets in global hedge funds at the end of the second quarter according to research firm, ETFGI. With US$2.971 trillion in assets, ETFs have moved past global hedge fund assets, which stand at US$2.969 trillion. There are 5,823 ETFs listed globally versus 8,497 hedge funds according to Hedge Fund Research (HFR).

Since 2008 investors have been focused squarely on costs, liquidity and transparency. While ETFs have easily fit that bill, hedge funds have faced an uphill battle, especially as positive equity performance has made index investing more compelling. ETFGI points out that the asset-weighted average annual cost of ETFs is just 31 basis points (or less than a third of a percent) while hedge funds typically charge 2% of assets and 20% of profits.

ETFGI also crunched the performance numbers. In the first quarter of 2015, the HFRI Fund Weighted Composite Index was 2.3%, just 1.3% higher than the 1% return of the S&P 500 Index.

Tim Edwards over at Indexology expands on this by challenging the idea that hedge fund performance is difficult to replicate. Edwards takes a theoretical hedge fund portfolio with 50% allocated to U.S. bonds and the remainder in global equities. He uses the S&P U.S. Aggregate Bond index and the S&P Global 1200 and then compares performance over five years to the HFR Fund-Weighted Composite Index.

The index-based strategy outperforms—until you add a 1.5% per annum fee and a 15% cut of profits to it. At that point the two match pretty closely. His point—“the average hedge fund looks like a fixed blend of cheap investments, at high cost.”

Now, I’m not 100% sure this is a fair comparison—not all hedge funds are created equal and the universe of disparate included in the HFR index is huge (nearly 8,500). For many institutional investors—especially pension funds—hedge funds will continue to play a role in providing downside protection, not shooting the lights out when it comes to performance.

But it does put the focus squarely on costs and performance and the value of active management. And that discussion is going to continue as the ETF space evolves offering a broader spectrum of products at a lower cost.

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