Clever investors are continually seeking out so-called anomalies and inefficiencies to boost opportunities, and for a brief time the edge is available to the early adopters. But the secret leaks out eventually and the outsized returns retreat. History is rife with examples.
Consider hedge funds, which thrive by exploiting unnoticed opportunities. Nice work if you can get it, but the relentless competition has dulled their edge. Some of those competitors are ETFs and mutual funds attempting to replicate hedge strategies for the masses—at a fraction of the cost.
“Many hedge funds simply repackage or lever cheap benchmark indices and sell it as expensive outperformance,” said Howard Wang in a conversation with Bloomberg. Wang is a former analyst at legendary hedge fund shop Bridgewater Associates and has started his own firm, Convoy Investments. “While true uncorrelated active management is more valuable than ever, investors need to make sure they are getting what they pay for,” Wang said.
Good advice, but easier said than done when you consider that the average hedge fund has dramatically underperformed broad U.S. equity indexes. The HFRI Fund Weighted Composite Index is ahead by an annualized 5.8% for the five years through this past July, according to HFR Inc. A modest return, far below the 16.8% annualized total return for the S&P 500 over that span.
Inexpensive ETFs have promised investors diversification far and wide. As they have drawn more assets, the results have been predictable: higher correlations. Consider how four formerly exotic markets compare in terms of rolling three-year correlations with the U.S. stock market (Figure 4).
A decade or two ago, it was relatively rare for investors to go into foreign stocks in developed and emerging markets or to own commodities and REITs. But now it’s become ordinary, thanks to the rise of publicly traded funds offering access to these markets at index product prices. The result is that there’s a lot less disparity between the returns of these investments and those of U.S. stocks. The diversification benefits are less.