Here's why ETFs are overtaking hedge funds

The active versus passive debate just got a new wrinkle, and one analyst thinks he knows why.

Exchange-traded funds, which are the primary vehicle for passive management, now have assets under management greater than hedge funds, according to a count from research firm ETFGI. ETFs primarily follow market indexes, while hedge funds use a mix of strategies to beat those same benchmarks.

Tim Edwards, senior director of index investment strategy at S&P Dow Jones Indices, set up an experiment that put a blend of low-cost ETFs against their more expensive hedge fund brethren.

What he found essentially was that his effort to mimic hedge fund strategy using indexes—half focused on international stocks, the other half on bonds—easily beat out a popular gauge of hedge industry overall performance, the HFRI Fund Weighted Composite Index. However, the results changed when he factored in the fees.

Trader on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters
Trader on the floor of the New York Stock Exchange.

Most ETFs charge fees less than 0.5 percentage point. Most hedge funds still follow the "2 and 20" structure, or a 2 percent annual fee and 20 percent of returns. Edwards was generous, though, and only charged 1 and 15.

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Still, as shown in the charts accompanying this report he compiled on this study, both strategies returned about the same when factoring in fees. Edwards' finding:

One conclusion to draw is that perhaps there is a market for a product offering a 50/50 split of U.S. bonds and global large-cap equities, at a highly remunerative cost structure. The other conclusion, perhaps shared by those whose continued flight to low-cost index funds are making the headlines today, is that the average hedge fund looks like a fixed blend of cheap investments, at high cost.

In recent times, ETFs have gotten significantly more creative in devising products. The hottest one in 2015 is currency hedging, while other managers are coming up with a slew of high-beta and even active ETFs. There also are a handful of funds out there that seek to mimic the strategies of top investors like Warren Buffett.

Of course, there are multiple caveats here.

First is that Edwards works for a firm whose stock in trade is providing the markets with indexes to follow.

Second, and this is sort of minor, but there is some disagreement over whether ETFs technically have surpassed hedge funds in assets. EVestment estimates total AUM for the hedges at $3.118 trillion, while BlackRock, the top ETF firm, put the global total for ETFs at $2.945 trillion as of June. The ETFGI tally had ETFs with $2.971 trillion versus $2.969 trillion for hedge funds.

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Third, 2015 has been a much better year for active management. After years of languishing, 49 percent of active managers are beating their benchmarks, the best since the financial crisis, according to a recent tally from Bank of America Merrill Lynch.

Fourth, hedge fund investors might take issue with the idea of using a benchmark like the HFRI index to gauge industry performance. They argue that the idea is not to pick a manager from the bunch but rather to find those that outperform.

Doing so, though is easier said than done.

Historically speaking, past performance often is inversely correlated to future results.

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"The challenge in investing in active managers is picking the good ones," Edwards said in an interview. "The average ones just are not good enough."