How Exchange-Traded Funds Are “Disrupting” Investing

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

The buzzword among investors today in Silicon Valley is “disruptive.”

Companies like Airbnb for hotels, Uber for taxis or Netflix for television have caused these traditional business models to crumble thanks to disruptive ways of doing business. Here’s why I believe exchange-traded funds (ETFs) are doing the same thing in the world of investing.

2017: Breakout Year for ETFs

I predict 2017 will go down as the year cryptocurrencies went mainstream.

In contrast, the explosion in the ETF industry has gone strangely unnoticed. Maybe it’s because ETFs aren’t brand-spanking new.

The first ETF was launched in Canada back in 1990. Yet, it’s only 27 years later that the ETF growth has hit a tipping point.

In 2015, ETF inflows grew under 6%. By 2016, assets rose over 8%, when global net inflows reached $379 billion.

This year, inflows are on track to surpass $600 billion.

That’s an astonishing 58% rate of growth.

At the end of April, 313 providers managed 7,000 ETFs across the globe. Today, total ETF assets have reached $4.5 trillion.

In contrast, Bitcoin’s collective market value stands at only $185 billion –- or 4% of the value of all ETFs.

Why ETFs Will Overtake Mutual Funds

Some experts predict ETFs could overtake mutual funds as soon as 2020.

I may disagree with the year of the prediction. But it’s hard to argue that it’s not inevitable.

After all, compared to traditional mutual funds, ETFs offer more choice at lower cost and with fewer tax hassles.

First, ETFs are infinitely flexible. ETFs offer a range of investment themes limited only by marketers’ imaginations. Today, ETFs invest in all major asset classes, such as stocks, bonds, fixed income, commodities and currencies. There is even an ETF for Bitcoin.

ETFs also track well-known investment strategies ranging from Dividend Aristocrats and insider buying to hedge funds’ top picks. Heck, you can even invest in a robotics ETF or in a Russian small-cap ETF.

Second, ETFs are generally less expensive than their mutual fund equivalents. And they are tax-efficient compared to a mutual fund.

Third, even traditional index fund investors have reason to prefer ETFs.

“Smart beta” ETFs tweak traditional index funds to generate market-beating returns. They invest based on strong fundamentals, value or even by merely weighting stocks equally across a portfolio.

Some ETFs even bet against the market, that is, they profit handsomely when markets go down.

The diversity of ETF strategies available to you today is astonishing. That’s why I like to think of traditional stock investing much like playing checkers.

Meanwhile, assembling a portfolio of ETFs is more like playing three-dimensional chess.

How ETFs Are Disrupting Hedge Funds

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It is not just mutual funds that are trying to weather the assault from ETFs.

I also expect ETFs will disrupt a big chunk of the hedge fund industry beyond recognition.

ETFs first surpassed the global hedge fund industry in size in 2015.

Today, ETFs manage over $1 trillion more in assets than hedge funds do.

Here’s why ETFs represent an existential threat to many hedge fund strategies.

First, hedge funds offer investors complex strategies which profit whether the market goes up or down.

In doing so, hedge funds have set themselves a high hurdle. And it’s not one that many hedge funds have jumped, as hedge funds have trailed the market over the past decade.

Meanwhile, these strategies don’t come cheap. Typically, hedge funds charge a 2% annual fee based on assets, as well as 20% of any gains.

Second, successful ETF strategies have shed light on the dirty little secret of hedge fund investing. Computers can replicate many hedge fund strategies and offer similar performance. Moreover, with fees of 30 to 70 basis points, ETFs cost a fraction of what hedge funds charge.

In fact, systematic strategies regularly outperform human hedge fund managers. Merger arbitrage, momentum-based and managed futures hedge funds have proven particularly vulnerable.

Third, ETFs democratize investments. New ETFs offer hedge fund-style strategies to retail investors who otherwise would have never invested in hedge funds. Investors also can access their capital readily, in contrast to hedge funds, which offer less liquidity.

The hedge fund industry is already on the defensive.

In July, London-based Aspect Capital — a quantitative hedge fund — launched an ETF to meet demand from clients.

One expert even predicted that many hedge funds will transform into research labs for low-cost ETFs in 10 years.

What’s the takeaway?

I believe 2017 marks the tipping point for ETF investing.

Many retail investors are just hearing now about ETFs and the myriad of strategies they offer.

Long after cryptocurrencies have come and gone, ETFs will still be thriving.

And market historians will remember 2017 as the year of the ETF.

In case you missed it, I encourage you to read my e-letter article from last week on the lesson Warren Buffet learned from Silicon Valley.

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