The Coming ETF–Hedge Fund War

Research firm Tabb Group warns hedge funds that ETFs could eat their lunch.

Illustration by II

Illustration by II

Hedge funds are in danger of losing a battle with low-cost exchange-traded funds. A new study from research and consulting firm Tabb Group evaluated how health and technology-focused hedge funds have fared against similar ETFs.

The results were mostly bad news for hedge funds. Two of the largest ETFs in each sector outperformed their respective hedge fund index counterparts. Hedge funds did, however, provide a smoother ride for investors.

Tabb compared ETF performance with BarclayHedge indexes, which use data reported by individual hedge funds. All performance figures were net of fees.

Pension funds and other large institutional investors have been adding so-called alternative beta products run by algorithms in pursuit of hedge fund-like exposures at a far lower cost than the real thing. Asset managers have facilitated the shift by taking advantage of technology to improve alternative beta products.

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Tabb compared the BarclayHedge Healthcare & Biotechnology index to the $19.5 billion Health Care Select Sector SPDR ETF and Vanguard’s $9.5 billion Health Care ETF. From 2014 to 2018, Tabb found the “performance of XLV [the SPDR fund] has been closely aligned with that of the hedge fund index.” In 2017, for example the SPDR fund returned 21.81 percent; the index returned 21.77 percent. In addition, the SPDR ETF beat the index four of the last five years.

“From a very high level, it appears XLV, which is basically a buy-and-hold portfolio that focuses on the health care sector, performs in-line with the average hedge fund that is actively managed,” according to Tabb. While the ETF and the index are highly correlated, the index’s annualized volatility was 11.77 percent, compared to the ETF’s volatility of 13.29 percent.

The Vanguard fund beat the index by an average of about 2.5 percent over all five years studied by Tabb. Like the SPDR, the Vanguard fund was also highly correlated to the index and had higher volatility than the index.

According to Tabb, $100 invested in the each of the two ETFs would have yielded about $169. An investor that socked away $100 in the hedge fund tracker over the same time frame would have walked away with only $152.

Technology-focused vehicles produced similar results. Tabb compared the Vanguard Information Technology ETF and the Technology Select Sector SPDR fund to the BarclayHedge Technology Index. The SPDR fund beat the index in three of the past five years. Vanguard’s fund beat both the SPDR and the index. Vanguard’s fund outperformed the index in four of the five years. The end result: $100 invested with Vanguard would have yielded $200 over the time period, while $100 in the SPDR would have turned into $189. Investors that bet on hedge funds would have would up with only $140.

“In each case here, the ETFs outperformed the hedge fund index. That performance, however, was always accompanied by higher volatility of returns,” noted the authors of the Tabb report.