Over the last few years, a major trend in money management has been money flowing out of actively managed funds (such as hedge funds) into passive index funds and exchange-traded funds (ETFs).
Hedge funds were originally sold as a low volatility, high return investment vehicle. However, in the last decade, they have been more like a low volatility, low return asset class. One thing people tend not to pay enough attention to is the correlation hedge funds have to major traditional asset classes. Many hedge funds’ returns can be replicated with a 50% equity and 50% bond asset mix.
On the other hand, ETFs have seen tremendous growth in the last few years. ETFs are one part of the “equitization of trading” trend. Equity market makers are moving into fixed income and derivatives markets and applying what they have learned/built in equity trading to the new asset class. Ken Griffin from Citadel said the company was not in the swap market making business three years ago; now, they are the number two market maker in swaps. This type of growth and disruptive power is a big threat to traditional market makers. Over the next few years, more and more asset classes may come to be traded like equities; the transaction cost could decrease and market transparency may improve.
Because of their popularity, the fund flows of ETFs have become a good indicator of investor psychology. As of the end of April, the two ETFs that received the largest inflows were SPDR Gold Trust (GLD) and iShares Edge MSCI Minimum Volatility USA (USMV).
It is not surprising to see the GLD ETF as the flow leader, given the recent revival of interest in the yellow metal. I am hearing a lot of famous hedge fund managers talking bullish about gold throughout the last few months, which makes me wonder if this trade is getting crowded. However, today's chart shows the history of total shares outstanding in GLD -- it reached 420 million in 2011 and 2012, and now it stands at about 288 million -- these numbers provide a different picture and signal that the trade is not as crowded as it feels.
The second most popular ETF is USMV. This ETF holds mega-cap, dividend stocks in non-cyclical sectors. This fits well with current investors’ mentality. There is a lot of uncertainty in the market and investors are nervous, so they invest in risk markets but try to hide in a safer corner of the risk market.
We’ve seen the phenomenon of safer risk assets outperforming other assets in many other markets. I understand the motive behind it, but I think this is getting dangerous because too many people are taking this strategy. A crowded position tends to always be risky no matter how safe the sector or asset is. “Nifty fifty” is a good story to read about this kind of conservative risk-taking mentality.
In the current market, I think the risk-reward profile is still not favorable. The market is pricing in a very dovish Federal Reserve (Fed), a stabilized emerging market, healthy profit growth for corporations and is ignoring the simmering inflation pressure. With the Fed on a hiking path, share buybacks slowing down, corporate leverage rising to high levels, and monetary policy losing its magic, the risk is more towards the downside than upside.
Key Takeaway: For hedge fund investments, the correlation is much more important than volatility. ETFs provide a new way to gain liquidity in fixed income markets. Recent ETF flows are showing a more conservative risk-taking behavior, which can prove to be dangerous due to crowdedness.
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