Small Investors And ETF Industry Trends

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Includes: HYG
by: Invest With An Edge

By Peter Mauthe

Several recent articles, such as this one from Seeking Alpha, note that individual retail investors appear to be benefiting from the trend of using ETFs in more portfolio applications. According to Seeking Alpha, assets in ETFs exceed the assets in hedge funds, which I thought was interesting. But then I thought back over my 40-plus years in the finance industry and realized that this makes perfect sense.

Hedge funds came into being because there were investment strategies and financial instruments that the small, individual investor could not access. Structured properly as a private fund (known today as hedge funds), these funds allowed sophisticated investors to pool their money and take advantage of these strategies and instruments. Some of these strategies include securities arbitrage, long/short strategies, and leveraged global strategies. Some of the financial instruments unavailable to the small investor included commodities, financial futures, foreign currencies, and swaps. The growth of the hedge fund industry attracted some of the best and brightest portfolio managers. As a result of the benefits of highly talented portfolio managers, attractive returns, and the ability of the fund to manage risk, sophisticated investors moved large amounts of money to these private funds even though these funds charged a premium price for their services.

Through the years investment markets evolved, as have the regulations controlling what funds are allowed to do and invest in. Today mutual funds and ETFs are permitted to use many of the same financial instruments once reserved only for sophisticated investors. This means that individuals are able to access many of the markets, strategies, and financial instruments once only available to those able to meet the high minimums and restricted liquidity required by hedge funds. This is driving more benefits to individual investors than may be evident on the surface. For example, some of the elite portfolio managers are now coming out of the hedge fund industry and entering the mutual fund and ETF industry. This migration of money and talent means increased mutual/ETF fund capabilities and lower industry costs, which are passed on to investors in the form of lower fees.

This reminds me of another article I read this past week from Bloomberg, which reported that Harvard Endowment is letting go of about half of its 230 investment staff as it closes internally operated hedge funds. The article also mentioned that Harvard Endowment's largest single holding is now the iShares iBoxx High Yield Corporate Bond ETF (NYSEARCA:HYG). According to the article, the endowment will shift much of the portfolio management to a growing number of outside money managers. This is not much different from individual investors selecting managers to manage their assets in investment accounts of all types.

Phil Mackintosh and Rachel Liang of KCG reported some interesting fund facts in a section of their morning comments on May 22, 2017: There is a common belief that retail investors are taking money out of stocks and buying domestic equity ETFs. In fact, over the past 10 years, investors have pulled $2 from stocks for every $1 invested in domestic equity ETFs. The balance of the dollars raised from stock sales went into bond and international equity ETF purchases. This also suggests that retail investor buying of domestic equity ETFs has not driven stock prices higher because there have been more individual stocks sold than bought via ETFs.

Regulatory Update: Last week the SEC decided to review the previous staff approval of the 4x leveraged funds that I reported on last week.

Disclosure: Author has no positions in any of the securities mentioned and no positions in any of the companies or ETF sponsors mentioned. No income, revenue, or other compensation (either directly or indirectly) is received from, or on behalf of, any of the companies or ETF sponsors mentioned.

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