Financial crisis put mutual funds, hedge funds and ETFs on a three way collision course

In February 2008, we told you about a report that predicted recent financial turmoil would accelerate the convergence of mutual fund and hedge fund industries.  Little did we know that the rest of 2008 would yield so much more financial turmoil.  So did that ensuing annus horribilis further accelerate the convergence trend?  “Yes”, according to a recent report by Citi Prime Services (see previous coverage); “yes”, according to a recent report by BNY Mellon (see previous coverage) and “yes”, according to a recent report by SEI (see previous coverage).

Long-time readers may also remember that in November 2006, we wrote that, although they had opposing objectives, hedge funds and ETFs actually had a common ancestry.  We described them as “separated at birth” because they each represented opposite sides of the same coin.  That coin was an actively managed mutual fund and those sides were alpha and beta.

Four years later, Citi’s data confirms this trend.  In the chart below from the report (click to enlarge) you can see that both ETFs and hedge funds have grown at the expense of actively managed equities.

“Active” equity mutual funds are down 10 percentage-points from around 78% of all U.S. equity mutual fund assets to around 68% while ETFs have increased by a half (14% of assets to 20% of assets) and hedged and alternative strategies are up by the same proportion (from around 8% to around 12%).  Coincidence?  Not according to Citi…

“…concern about “active” long-only managers’ ability to generate returns has fueled a shift in the manner by which many institutional investors are obtaining their beta exposure.  There has been a dramatic increase in the growth of “passive” index tracking funds and ETFs'”

So although most investors aren’t yet trying to literally replicate their active mutual funds with (more optimal) combination of ETFs and market neutral hedge funds, the aggregate effect of their biases toward these two poles is to bifurcate the industry along the lines of alpha and beta.  This is reflected in a trend that McKinsey & Co. has called the asset management industry “barbell” (see related posts here and here and chart below from their 2006 report).

No longer content to stay in their own corners, both the ETF industry and the hedge fund industry have an eye on the rest of the active mutual fund pie.  ETF’s are stepped out of their traditional role of providing only passive risk and hedge funds are become more liquid and transparent.  Both strategies put them in direct competition with active mutual funds, a trend Citi describes as active mutual funds “being squeezed from both sides” (what McKinsey describes as a “vise-like squeeze” – see related post).

The chart below from the Citi report makes the case that hedge funds are on a collision course with regulated (mutual and UCITS) funds.

In fact, battalions of hedge funds have already assembled at the border of Hedgistan (blue shaded area above right) and Long-only-stan (white area above left).  How big is this force?  This big, according to Citi’s sources:

While UCITs-compliant hedge funds have yet to recover from the shellacking they took in 2008 , U.S. “alternative mutual funds” more than doubled in 2009. (See charts below from the SEI report using same sources.)

The fact that hedge funds have nearly recouped their 2008 drawdown is sure to further fuel this trend on both sides of the pond.  In fact the words of one pension consultant interviewed for the Citi report should be a concern for traditional active long-only managers…

“A lot of investors are saying , ‘Hey’ my Equity book hasn’t performed.  I shouldn’t have so much of my risk correlated at 1 with beta.  Let’s go into a hedged vehicle.’…allocations to Equities as a whole are going down – if an investor was 60% in Equities, half of that is moving to hedge funds.”

Regulatory changes resulting from the financial crisis are likely to contribute to the convergence – at least in the eyes of institutional investors. The chart below from the BNY Mellon report shows that nearly half of institutional investors felt regulatory changes would “accelerate” convergence.

The financial crisis will have many legacies.  But it appears that once of the most enduring may that investors now look beyond superficial labels like “hedge fund” and “mutual fund” and develop a keener sense of what it is they want and who they want it from.

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