Leading hedge funds have long been recognized for their potential to deliver substantial returns for investors, a feat often attributed to their sophisticated active management strategies. However, this high level of management comes with a significant cost, primarily in the form of substantial fees. Bob Elliott, CEO of Unlimited, recently discussed his firm’s unique approach to alternative investments and presented a compelling argument for why alternative Exchange Traded Funds (ETFs) may be poised to outperform traditional hedge funds, particularly after accounting for all associated expenses.
The Hedge Fund Landscape: A Realm of High Returns and High Costs
Hedge funds, often perceived as exclusive investment vehicles, operate within a complex ecosystem designed to generate alpha, or returns above market benchmarks. Their active management involves a wide array of strategies, including global macro, equity long-short, and event-driven approaches. These strategies require deep market insight, rigorous quantitative analysis, and often, the ability to take both long and short positions across various asset classes.
Bob Elliott’s career trajectory offers a unique perspective on this industry. He began his journey at Bridgewater Associates, a firm that pioneered systematic macro investing. During his nearly 15 years there, Elliott gained an in-depth understanding of macroeconomic drivers and developed systematic investment strategies. He noted that Bridgewater’s innovation lay in applying the systematic rigor found in areas like equity long-short to the macro investing space, transforming it from an art practiced by savants to a more quantifiable discipline.
"Bridgewater’s real innovation… was bringing the sort of rigorous and systematic approaches that had existed for a long time in things like equity long-short, and areas like that, and bringing that understanding into the macro space," Elliott explained. He highlighted that his academic background in pure sciences, specifically botany, unexpectedly equipped him with a systematic approach to research and problem-solving, which proved invaluable in the world of finance.
Understanding Macroeconomics: Beyond the Textbook
Elliott emphasized that the real-world functioning of the macroeconomy diverges significantly from what is typically taught in academic settings. His approach, honed at Bridgewater, centers on understanding intuitive cause-and-effect drivers and then quantifying these linkages. For instance, a rise in inflation above expectations would logically lead to an increase in bond yields. The systematic aspect involves quantifying the pressures on inflation relative to what is already priced into the bond market.
"Systemization is the quantification and using that understanding in a repeated way over and over and over again, right, in a way that is disciplined," Elliott stated. This discipline is a key differentiator from discretionary investing, which can be susceptible to overreactions or underreactions to incremental information. Systematic approaches offer a disciplined framework for synthesizing vast amounts of data and executing strategies as designed.
Even the most successful macro investors operate with a probabilistic edge. Elliott posited that top macro investors might be correct on approximately 55% of their bets in any given month, and wrong about 45%. While this might seem modest, when applied across hundreds of markets over time, this slight edge can translate into significant outperformance. This concept draws an analogy to being a skilled blackjack player, where a consistent advantage, however small, leads to long-term success.
The Nuances of Market Reactions and Predictive Modeling
The inherent complexity of markets, with reactions to initial actions and policy responses, creates layers of uncertainty. Elliott addressed this by framing the goal of systematic investing not as achieving perfect foresight, but as gaining an edge in predicting the actions of various market participants. He likened the Federal Reserve’s decision-making process to a constrained set of rules driven by incoming data on growth and inflation. By understanding these inputs and the Fed’s response function, one can predict their behavior.
"The idea of saying that, you know, various folks’ actions are driven by, you know, a set of not necessarily cost effect rules. They’re not rules, but there are motivations," Elliott elaborated, suggesting that motivations and access to resources are quantifiable aspects of market behavior.
The Broad Spectrum of Alternative Investments
The "alternative investments" umbrella encompasses a diverse range of asset classes, strategies, and structures. A primary categorization is between liquid and illiquid alternatives, with hedge funds and hedge fund ETFs largely falling into the "alternative strategies" bucket. Elliott’s passion for these strategies stems from his desire to understand the entire system of markets and economies, viewing them as complex systems in which humans are both participants and observers.
"What investment strategies are, are ways in which you can express your understanding relative to how the rest of the market understands the world because that’s essentially what’s priced in," he explained. Success in investing, therefore, is a demonstration of incrementally superior understanding. Conversely, errors provide opportunities for learning and refining one’s approach.
Hedge Funds in 2022: A Year of Resilience
The year 2022 presented a challenging market environment, with traditional 60/40 portfolios experiencing significant drawdowns. However, alternative investments, in general, demonstrated resilience. Managed futures, for instance, saw substantial gains of around 20% after a decade of subdued performance.
Regarding hedge funds specifically, aggregate performance in 2022 was notably strong. Elliott noted that the hedge fund industry, encompassing various strategies like managed futures, equity long-short, and global macro, performed impressively in a market where the 60/40 portfolio was down between 15% and 20%. Even equity long-short strategies, often criticized in the media, delivered significant alpha relative to passive investing benchmarks, falling only about 8% compared to market declines of 15% to 20%.
"Hedge funds in aggregate, did pretty well in a challenging market environment," Elliott stated. He highlighted that hedge funds are generally adept at capital preservation during difficult periods by reducing risk, lowering beta exposures, and seeking out value opportunities. This defensive posture was crucial in navigating the market turbulence of 2022.
Addressing the Pain Points: Fees, Access, and Taxation
Despite the strategic effectiveness of hedge funds, certain structural issues present significant challenges for many investors. Elliott identified several key pain points:
- High Fees: Traditional hedge funds typically charge management fees of 2% and performance fees of 20% (often referred to as "two and twenty"). This can significantly erode returns, even for strategies that are inherently strong. Elliott estimated that these fees can add between 300 and 400 basis points annually, diminishing the net benefit for investors.
- Tax Inefficiency: The limited partnership (LP) structure common to hedge funds can lead to unfavorable tax treatment, with annual distributions often taxed at marginal income tax rates, which can be higher than capital gains rates.
- Limited Access and Diversification: For smaller-scale investors, gaining access to the most successful and sophisticated hedge funds is often difficult. Many top-tier funds prioritize institutional investors and may even close to new capital, leading to a "negative selection" problem for those who can’t access the best. Diversifying across multiple hedge funds requires substantial capital or can lead to "fees on top of fees" through fund-of-funds structures.
- Administrative Burden: The paperwork associated with alternative investments, particularly the K-1 forms for tax reporting, can be burdensome for both investors and financial advisors.
The Unlimited HFND ETF: A Novel Solution
In response to these challenges, Unlimited launched the HFND Multi-Strategy Return Tracker ETF. This innovative product aims to replicate the gross-of-fees returns of the hedge fund industry by leveraging advanced machine learning techniques. The ETF seeks to provide investors with exposure to hedge fund-like strategies at a significantly lower cost and with improved tax efficiency compared to traditional hedge fund investments.
"The idea is, you know, if we can create… What investors care about in the end is their post fee, you know, their net of fee post-tax return, right? That’s what they really care about," Elliott explained. By using technology and proprietary strategies developed over decades of experience, Unlimited aims to "look over the shoulder" of hedge fund managers in near real-time, translate these insights into long and short positions in index products, and package them within the accessible ETF wrapper.
The HFND ETF offers several key advantages:
- Lower Costs: By utilizing technology and a systematic approach, Unlimited can offer management fees that are approximately a quarter of those charged by typical hedge funds.
- Tax Efficiency: The ETF structure is inherently more tax-efficient than traditional LP structures, leading to roughly half the tax burden.
- Accessibility and Liquidity: As an ETF, HFND has no minimum investment requirement, allowing investors to participate with as little as a single share. It offers daily liquidity, eliminating the redemption complexities often associated with private funds.
- Diversification: The ETF provides diversified exposure to a range of hedge fund strategies, addressing the diversification challenge faced by individual investors.
The Evolution of ETFs: Beyond Passive Indexing
The ETF structure, once primarily associated with low-cost passive indexing, is increasingly being utilized for more sophisticated active management strategies. Regulatory changes, particularly those enacted in 2020 and 2021, have allowed managers to implement more complex strategies within ETFs, provided they adhere to institutional-quality risk controls.
Elliott believes this marks a significant evolution in the investment landscape. "The ETF structure is the best structure for the investor. There’s no question about that. It’s liquid, it’s transparent, it’s, you know, it’s tax efficient," he stated. This investor-friendly structure, combined with the growing demand for sophisticated investment solutions, is driving the trend of alternative ETFs.
The Future of Investment Management: A Bifurcation of Fees and Strategies
Looking ahead, Elliott anticipates a rationalization of fees across the investment management industry, particularly in the context of a macroeconomic environment characterized by higher interest rates and potentially lower overall returns. He foresees a bifurcation within the hedge fund industry:
- Elite Managers: A select group of highly skilled hedge fund managers who generate unique alpha and justify their fees will continue to attract capital, primarily from large institutional investors.
- The Broader Industry: A significant portion of the hedge fund industry, where fees may not be commensurate with the value delivered, will face increased scrutiny. Investors seeking hedge fund-like exposure will likely gravitate towards more cost-effective and efficient solutions, such as alternative ETFs.
"There are absolutely hedge funds that deserve the fees that they charge… But that is also a relatively small portion of the hedge fund industry, and it’s a part of the hedge fund industry that’s very hard to access," Elliott observed. He added, "For the rest of the world… we’re gonna have a real reckoning of the rest of the hedge fund industry, where frankly, the vast majority of the hedge fund industry does not justify its fees."
The rise of sophisticated replication strategies within structures like ETFs promises to benefit investors by offering access to complex investment approaches that are diversified, more consistent, and significantly lower in cost. This transition is expected to usher in an era where investor benefit takes precedence over manager enrichment.
For those seeking to learn more about Unlimited and the HFND ETF, the company’s website, unlimitedfunds.com, offers detailed information and commentary. Bob Elliott also maintains an active presence on Twitter (@BobEUnlimited), where he regularly shares insights on macroeconomic trends and investment topics.
