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Democracy, the Markets and the Retail Investor


Democracy, the Markets and the Retail Investor - BONI

Financial markets are witnessing an increasing trend towards democratization. This is being achieved by a swathe of small retail investors leveraging social media platforms and trading using no-fee apps such as those provided by Robinhood or Charles Schwab.


 

The advent of technology has enabled smaller retail investors gain access to realms that were once the exclusive purview of high-net-worth individuals and institutions such as hedge funds and Private Equity firms (PE). Historically, investments in the financial markets were primarily managed by institutional investment that possessed significant resources and had deep levels of expertise available to them. However, technology, social media and product innovation have lowered the barriers to entry, enabling smaller retail investors with fewer resources to actively participate in all those markets.

Hedge funds have traditionally been the exclusive domain of sophisticated, high-net-worth investors seeking outsized returns through the use of complex models and strategies. They are characterised by their high fees, typically employing a structure, which charges 2% of assets under management (AUM) and 20% of any profits earned. Compared to the costs associated with investment in Index funds or exchange traded Funds (ETFs)favoured by smaller retail investors.

This structure with minimum investment thresholds and steep fees has hitherto been a barrier to entry for smaller retail investors. Such high fees substantially eat into the returns for investors in hedge funds. Especially when markets experience yield compression during periods of low interest rates. For instance, where a hedge fund generates a 10% return, the net yield to the investor will be significantly below that after management and performance fees are deducted. Contrast this with index funds or ETFs, which often have expense ratios as low as 0.1% to 0.5%, which ensures the bulk of any returns remains with the investor.


Another crucial dimension is performance. Historically, hedge funds were believed to offer superior returns through diverse methodologies including leverage, arbitrage, and derivatives. Some of the larger notable funds that are not accessible to small retail investors such as Ken Griffin’s Citadel LLC or Bridgewater Associates LLP, do frequently out-perform market indexes. However, empirical evidence shows that hedge funds often underperform their benchmarks. For example, the S&P 500 index has outperformed the average hedge fund over the last decade. According to data from Hedge Fund Research, many hedge funds have not only lagged behind broad indices but have regularly failed to recover fees and provide commensurate risk-adjusted returns.


In 2008 Warren Buffett famously bet $1 million against Protégé Partners LLC, a hedge fund, that an S&P 500 index fund would outperform a portfolio of hedge funds over a decade. The S&P 500 has a 10-year annualised return of 14.7%. The results were telling; by the end of the period, the S&P500 index fund had significantly outperformed the hedge funds. This outcome starkly illustrates the challenge hedge funds face in justifying their high fees in light of their actual performance. It also raises the question of the use of hedge funds period, where alternative investment options exist.

Some critics have been even more disparaging, Princeton University professor Burton Malkiel indignantly claimed in his bestselling book, A Random Walk Down Wall Street, that “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts”.


Compared to hedge funds or private equity, index funds and ETFs offer several advantages to small retail investors. Their foundational principle is to replicate market indices, thereby ensuring investors achieve market returns with minimal costs and minimal effort. This "passive" investment approach enables smaller retail investors to diversify their portfolios broadly without the need for active management or extensive market research.

A retail investor can purchase a single share of an ETF through a no-fee brokerage account via a mobile app. For instance, if an investor wants to invest in the technology sector but cannot afford to buy shares of all major tech companies, they could purchase a share of the Technology Select Sector SPDR Fund (XLK), which provides exposure to companies like Apple, Microsoft, and others in the tech sector. The overall simplicity and predictability of index funds and ETFs make them particularly appealing for long-term investors aiming to steadily grow their wealth.


Moreover, the rapid growth of the ETF market has underscored its appeal. ETFs provide liquidity, transparency, and tax efficiency. Unlike hedge funds and private equity, which may have lock-up periods and limited redemption windows, ETFs can be bought and sold on the stock exchange like any other stock, offering investors greater flexibility. Additionally, the transparency of ETFs means that investors know exactly what assets they hold, unlike the often opaque nature of hedge fund portfolios or PE.


The difference in performance of these investments can be attributed to several factors. The efficient market hypothesis (EMH) suggests that it is challenging to consistently outperform the market through active management. Given that hedge funds often employ highly complex strategies, the costs of these strategies – including transaction costs, research expenses, and the higher fees charged by managers – can outweigh the benefits. Moreover, the increased scrutiny and regulation of hedge funds have also constrained their ability to fully utilise certain aggressive strategies.


Yet hedge funds can still cater to a specific market segment, predominantly high-net-worth individuals and institutional investors seeking exposure to alternative assets and risk mitigation through uncorrelated returns. In turbulent market conditions, some hedge funds have demonstrated an ability to preserve capital and provide robust downside protection, which is of course valuable. However, the average smaller retail investor may not require such specialised services, especially at such a high cost.


Recently the use of Liquid Alternatives has emerged to provide a good option for smaller retail investors. Liquid Alternatives are investment vehicles that utilise alternative investment strategies, such as long/short equity, market neutral, managed futures, and global macro, but are structured as mutual funds or ETFs. This means that they are more liquid than traditional hedge funds that typically have lock-up periods and redemption restrictions. They are essentially a “lite” version that emulates hedge fund investment strategies.


One key advantage of investing in Liquid Alternatives for small retail investors is accessibility. Hedge funds have high minimum investment requirements, making them out of reach for most individual investors. Liquid Alternatives, on the other hand, typically have much lower minimum investment requirements, allowing retail investors to gain exposure to alternative investment strategies without needing a large amount of capital.


Another crucial benefit of liquid alternatives for small retail investors is the ability to easily buy and sell their shares on a daily basis, just like with traditional mutual funds and ETFs. This liquidity provides investors with more flexibility and control over their investments, allowing them to adjust their allocations or exit positions quickly if needed. This is important because although their investment rationale might be predicated on the Efficient Market Hypothesis, as the renowned economist John Maynard Keynes once remarked after experiencing substantial losses in the market himself, “markets can remain irrational for longer than you can remain solvent…”.

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