Differences between ETFs and hedge funds

ETFs vs. Hedge Funds: What’s Right for Investors?

There’s been a tremendous amount of noise and attention lately surrounding the ETF industry. For the first time, ETFs have beaten hedge funds in terms of investment dollar amounts. This recent news and the rising popularity of ETFs have left many investors wondering which of the two asset types is most appropriate for their portfolios. Here we quickly go over ETFs and how they compare to hedge funds on various scales such as goals, risk, liquidity, barriers to access, and more.

What are ETFs?

ETFs (exchange traded funds) are funds that track an index (such as NASDAQ, S&P 500, Dow Jones, etc.), commodities, or bonds. Investors who purchase shares of an ETF essentially buy shares of a portfolio that tracks the yield and return of its native index. Typically purchased by individual investors, ETFs are meant to replicate the market’s performance, not try to beat the market. Highly liquid, they can be bought or sold at any time during the day and trade like a common stock in a stock exchange.

 

Investment Dollars in ETFs Beat Hedge Funds for First Time

Recently in July 2015, articles touting the growth of the ETF industry have surfaced. The ETF industry, which celebrated its 25th anniversary this year, have some $2.971 trillion invested over 5,800 ETFS and ETPs (Exchange Traded Products). Compared to the hedge fund industry, which has been around for 66 years and has $2.969 trillion invested in hedge funds, the ETF industry is certainly growing fast. For the first time ever, there are more investments in ETFs than hedge funds.

 

Types of ETFs

Just like there are many different kinds of hedge funds strategies, there are also different types of ETFs that exist for investors. Popular ETF types include:

  • Equity Funds
  • Fixed-Income Funds
  • Commodity Funds
  • Currency Funds
  • Real Estate Funds
  • Specialty Funds
  • Derivative Funds

ETFs can also range from broad to very niche.

 

ETFs vs. Hedge Funds

So with the growing investment dollars pouring into ETFs, does this mean that investors should reconsider their investments in hedge funds and reallocate to ETFs instead? Let’s first make some quick comparisons. Below is a general overview of the major differences between hedge funds and ETFs. Of course, depending on the type of hedge fund strategy or ETF, things may vary slightly.

 

How ETFs compare to hedge funds

 

So Should Investors Go With ETFs Over Hedge Funds?

Despite recent news regarding a slump in hedge fund performances, hedge funds are still relevant for investors. Hedge funds are intended to better control certain aspects of risks, achieve capital preservation, reduce volatility, and provide more diversification and risk-adjusted returns. In addition, hedge funds have the additional infrastructure and capital, which enable them to be better equipped than individual investors to make timely and profit-maximizing moves. Therefore, depending on the investor’s risk profile, sometimes it may be better to spend time researching and analyzing hedge fund managers instead of searching for standalone opportunities that will require significant resources and ongoing maintenance.

When it comes to market correlation, because ETFs try to replicate the market, ETFs may be more subject to both traditional market risks and rewards based on the various securities that make up the underlying fund. Therefore, as securities in an ETF portfolio fluctuate, the ETF shares’ values will also increase and decrease. While both ETFs and hedge funds may apply traditional securities such as stocks, the strategies and goals are very different. Hedge fund managers typically seek to achieve positive absolute returns regardless of market direction or fluctuations. Of course, the relative returns of hedge funds are also used to evaluate their performance compared to other hedge funds and investments, often against hedge fund indices and benchmarks.

 

Before joining the ETF bandwagon, investors should consult their investment advisor and carefully consider their investment goals and risk appetite. While ETFs may be available to everyone, it may not be right for everyone’s investment portfolio.

 

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  • andre Boreas

    “Hedge fund managers typically use sophisticated, riskier strategies with
    the goal of realizing large capital gains and beating benchmark
    indexes.”

    That’s incorrect. HFs, for the most part, try to control the risk embedded in beta products like ETFs, not use riskier strategies. Also, usually the goal is to provide a a consistent stream of returns, with lower vol and with lower correlation to the markets. Not to achieve “large capital gains” or “beat an index”

    • Grace

      Thank you Andre for your response. You’re absolutely correct in your statement that hedge funds are designed to provide differentiated risk exposure, decreased volatility, and uncorrelated returns – all points with which we wholeheartedly agree and address in this article. As instruments intended to guard against the risk of loss, hedge funds also are not inherently riskier than products like ETFs; you’ll notice that the original sentence has been modified to reflect this. However, as important as absolute return performance is, we maintain that relative returns and alpha generating capability are still critical metrics that investors consider, especially when evaluating and comparing hedge funds. In this case, various hedge fund indices do serve a purpose, but I can see that this may have not been conveyed properly in writing. You’ll notice that the section also has been reworded to reflect this properly.