IT IS a victory for the humble—for the investment equivalent of a puttering hatchback over a gleaming Porsche. The exchange-traded-fund (ETF) industry is now bigger than the more established business of hedge funds. Assets in the global ETF industry were $2.971 trillion at the end of June, according to ETFGI, a research firm, $2 billion ahead of the hedgies’ $2.969 trillion, as calculated by Hedge Fund Research (see chart 1). In 1999 the ETF industry was less than a tenth the size of its ritzier rival.

ETFs are pooled funds, quoted on stockmarkets, that are designed to replicate the performance of an asset class. They usually do so by tracking a benchmark such as the S&P 500 (for American equities).

Once the fund is set up, portfolio changes are mechanical, responding to changes in the underlying benchmark. Funds can track almost anything from the gold price to commercial property. Some have extremely low expenses: Vanguard’s S&P 500 index tracker charges only a twentieth of a percentage point a year.  

Although hedge funds also invest across a wide range of assets, they take a quite different approach. Using far more complicated strategies, they aim to offer investors a superior service: either a higher return than achieved by the benchmark or a better balance of risk and reward.

Because they can sell short (bet on falling prices), they claim to prosper in all kinds of market conditions. In return for this sophistication, they demand higher fees: an annual charge of 2% or so and a performance fee of 15-20%, making their founders very rich indeed. Hedge funds aim to attract “the best and the brightest” managers to their industry; ETFs merely aim to be average.

ETFs target the mass market: the humblest retail investors can participate and could in theory put all their savings in ETFs. The hedge-fund industry has a narrower clientele: it targets the wealthy and big institutions such as pension funds and university endowments. It aims to manage just a small proportion of their portfolios.

Both ETFs and hedge funds have been growing at the expense of a much larger rival—the conventional fund-management industry made up of mutual funds and specialist investors that pursue so-called “active” strategies in an attempt to beat the index. In the late 1990s, when Wall Street was surging thanks to the dotcom boom, conventional managers could generate impressive returns. Since 2000 there have been two bear markets in equities and bond yields have sunk to record lows; conventional managers have struggled.

In a world of reduced returns, the low costs of ETFs are more attractive. For the hedge-fund industry, in contrast, low returns are a problem. Most managers have to invest in the same equity and bond markets as everyone else. In the 1990s hedge funds enjoyed seven years of double-digit average returns. In the first decade of the 2000s, they managed three such years. In this decade, there has been just one.

Even when it comes to avoiding losses, the industry’s record has deteriorated. There were no years of negative returns in the 1990s, but three since 2000. Hedge funds’ reputation took a hit in 2008, when they lost a lot of money. On a rolling five-year basis, their returns have been disappointing (see chart 2).

The deteriorating performance is probably not a coincidence. Hedge funds sold themselves as clever and flexible enough to take advantage of opportunities that conventional fund managers neglected. But there may not be enough such opportunities for an industry with nearly $3 trillion of assets to exploit.

As a result, hedge funds market themselves rather differently from the way they used to. In the 1990s, the heyday of managers like George Soros, the industry sold itself on its ability to generate outsize returns. Nowadays it talks of the ability to generate “risk-adjusted returns”—steadier profits with less volatility. Where once they appealed largely to the rich, hedge funds now target institutions. A recent survey found that a majority of managers expect the bulk of their new money to come from pension funds over the next few years. Some pension funds use a “core-satellite model” in which the bulk of their money is in ETFs (and other low-cost funds that track indices) with the rest in specialist vehicles, including hedge funds and private equity.

Yet the steady return claimed by hedge funds can be replicated, or indeed beaten, with ETFs.

S&P, an index provider, calculated the return over the past five years from a portfolio comprising 50% American bonds and 50% global equities. This portfolio easily outperformed the average return from hedge funds. S&P then deducted hedge-fund-style fees from the model portfolio; the result tracks hedge-fund returns very closely. It looks, in other words, as if hedge funds are a very expensive way of buying widely available assets. Last year CalPERS, California’s public-sector pension fund, announced it was selling off its investments in hedge funds, citing both complexity and costs.

ETFs have also faced criticism. Jack Bogle, the founder of Vanguard, an index-tracking firm, has argued that the ease of dealing in the funds may cause retail investors to trade too much, switching in and out of asset classes in a vain attempt to time the markets. A more widespread concern relates to liquidity. All ETFs allow investors to redeem their holdings instantly, but some of the assets they own, such as corporate bonds, trade infrequently. They thus face a potential problem if prices fall sharply and a lot of investors want to sell at once. That might force them to delay or limit redemptions (imposing “gates”, in the jargon). Some see this as the trigger for the next market crisis.

The industry’s defenders argue that the sector got through the 2008 downturn without a problem. Alan Miller, who used to run a hedge fund but now manages assets for individuals at SCM Direct, which specialises in ETFs, points out that “ETFs have been tested in a lot of market environments and not a single one has failed.”

Short of a calamitous collapse at an individual fund, the ETF industry is likely to keep on growing.

Ten years from now, it may be double or treble the size of the hedge-fund sector. The race is not always to the cheap, but that’s the way to bet.