Top 3 ETFs Owned by Hedge Funds

An exchange-traded fund, or ETF, contains a collection of stocks but trades just like a single stock. ETFs can be used to track a major index such as the S&P 500, or focused around a specific sector, from tech to health care and even robotics. They can also be focused around certain characteristics such as “value” or “growth.”

Can you beat the market?

Multiple studies have shown most active managers tend to underperform their market index on average. For example, according to Morningstar, out of the 3,000 active funds Morningstar analyzed, only 47% survived and outperformed their average passive counterpart in the 12 months through June 2021. Long-term S&P Global data shows, “Over a 15 year period, 87% of active fund managers tracking larger cap stocks underperformed the S&P 500.”

The good news is, in recent years this has been better, with approximately 58% of fund managers being outperformed by benchmarks.

Source: S&P Global Data

If even fund managers for whom investing is their entire job find it incredibly difficult to outperform the market, how difficult is it for retail investors to gain an edge? Those of us investing our own money don't have access to nearly as much information as fund managers do.

Why is it difficult to outperform?

The market is notoriously competitive, and any market inefficiency is usually exploited rapidly. However, part of the reason why hedge funds tend to underperform is because they charge higher fees than a typical index fund, such as 2/20 (2% management fee and 20% of profits above a certain threshold). Additionally, it's rare for anyone to have a fully accurate grasp of where a company or its stock is headed; part of it always comes down to luck. In the case where you only have part of the information, that part might also lead you to the wrong decision.

Jack Bogle (who founded Vanguard) once famously said, “Rather than trying to find the needle in the haystack, just buy the haystack.”

It's true that some legendary investors have consistently beaten the market, such as Warren Buffett (Trades, Portfolio), who has generated ~20% returns for the past 57 years at Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). However, for many of us, we might be better off casting our lot with ETFs.

Even hedge funds and active managers buy ETFs sometimes, as these can be a great way to secure average performance for part of their funds. Sometimes, they can attempt to pick the “cherries to go on top” from among ETFs, as a former Citigroup (C, Financial) trader said in a recent interview with me on my YouTube channel, Motivation2Invest.

This interview inspired me to look at which ETFs are most frequently bought by fund managers. According to GuruFocus data, these are the top three ETFs that most commonly appear in investing gurus' portfolios.

1. S&P 500 ETF Trust (SPY, Financial)

This ETF tracks the S&P 500 index. These are the 500 largest and most valuable (by market capitalization) companies which trade in the U.S. There is also a minimum profit requirement for S&P 500 entry consideration, thus you can be sure this fund really does contain the best of the best in the U.S. This is also Warren Buffett (Trades, Portfolio)’s favorite index to recommend to investors, as he has said many times in the past.

This fund is owned by 14 guru investors and offers a 1.14% dividend yield. The expense ratio is a rock bottom 0.09%.

Since the ETF’s inception in 1993, it has returned ~10% per year, which is in line with the S&P 500 index. In the past 10 years, it has returned an incredible ~13.5% per year average. However, this was mainly driven by the bull run in the FAANG tech stocks which make up approximately 25% of the index.

The fund's top stocks by weighting include Apple (AAPL, Financial), Microsoft (MSFT, Financial), Amazon (AMZN, Financial), Alphabet (GOOG, Financial)(GOOGL, Financial), Tesla (TSLA, Financial) and Berkshire Hathway.

The price-earnings ratio for the ETF has recently corrected back down to average levels of ~21, which means it looks to be fairly valued in my view.

2. SPDR Gold shares ETF (GLD, Financial)

Since ancient times, gold has often been used as a currency and store of wealth. Gold is also often seen as a hedge during times of inflation, as there is a limited supply. Many major governments keep vast gold reserves; for example, the U.S. houses 8,133.5 tons of the yellow metal, while Germany has 3,359.1 tons, Italy has 2,451.8 tons, France has 2,436.5 tons and Russia has 2,301.6 tons.

Gold is also known as a “fear” asset and is where investors retreat to during times of uncertainty. Recently, bitcoin has been called “digital gold,” but so far there's not enough historic data to determine how well it has held up, and the asset is notoriously volatile.

The return for gold has been great over the past five years with a 9% annual rate of return achieved. This was mainly driven by the post financial crisis boom. Over a 10 year period, the return has been less special with a 1% annual return, and surprisingly, this last year's performance has shown a decline of 4% (despite the high inflation).

The expense ratio for this ETF is much higher (0.4% vs 0.09% for S&P 500 ETF). This is due to the extra cost of managing a physical asset such as gold, which may include vaults and security. However, it seems hedge funds don’t mind paying the extra, and 11 of the premium gurus followed by GuruFocus hold it as of their most recent quarterly filings.

The world's largest hedge fund manager Ray Dalio (Trades, Portfolio) has always been a big bull on gold, whereas investors such as Buffett are not really big fans as it doesn’t “produce anything."

3. iShares Russell 2000 Value ETF (IWN, Financial)

This ETF tracks the Russell 2000 Index. These are the 2,000 smallest stocks in the Russell 3000 index. Thus, this fund is considered to be great for tracking small cap stocks. Historically, small caps tend to outperform large caps, and the small cap “premium” is often talked about. This specific ETF also buys those small cap stocks which show characteristics of being undervalued.

The past five years' performance shows an incredible 27.96% return in 2021, with just a 4.5% return in the growth stock bull market of 2020. But also be aware some recent returns are negative, with a loss of 12.9% in 2018.

In terms of valuation, the fund is trading at a price-earnings ratio of 12.5, which is slightly below the ETF's average of approximately 15%.

Final thoughts

ETFs which track major market indexes are a proven way to outperform the majority of active managers. The funds mentioned in this article are the most popular ones held by the premium gurus followed by GuruFocus and have fairly low expense ratios, while also generating great performance. ETFs offer an easy way to gain diversification and decent performance at a low cost. The only negatives of ETFs are the expense ratios and the fact that the upside is usually limited. Dont expect a 10-bagger from an ETF, but a more reliable return generally compounds well and builds wealth over time.