Leading hedge funds have long been recognized for their potential to generate substantial returns for investors. However, this active management prowess comes with a significant cost, often manifesting in high fees and limited accessibility. Bob Elliott, CEO of Unlimited, recently shared his perspective on these challenges and introduced a compelling alternative strategy through HFND, an ETF designed to replicate hedge fund returns at a lower cost and with greater efficiency. In an interview on The Alternative Investment Podcast, Elliott articulated his belief that alternative ETFs, like HFND, hold the potential to outperform traditional hedge funds after accounting for fees.
The evolving landscape of alternative investments has seen a surge in interest, particularly following the performance of various alternative strategies in 2022, a year marked by significant drawdowns in traditional 60/40 portfolios. While many sectors within alternatives demonstrated resilience, the conversation around the accessibility, cost, and effectiveness of traditional hedge funds remains a critical one for investors and financial advisors alike.
Unpacking the Hedge Fund Model: A Journey from Bridgewater to Unlimited
Bob Elliott’s career in finance began at Bridgewater Associates, a firm renowned for its systematic approach to macro investing. Joining in the early days, when the firm managed just a few billion dollars, Elliott spent nearly 15 years developing a deep understanding of macroeconomic drivers and constructing systematic investment strategies. This foundational experience provided him with a comprehensive view of various asset classes and the power of quantitative methods in identifying investment edges.
"Bridgewater’s real innovation in that space 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 noted that his academic background in botany initially seemed distant from finance, but his inherent interest in investing and the macroeconomy led him to a field where continuous learning is paramount.
Elliott’s early career at Bridgewater provided him with a unique perspective on how the global economy functions, a stark contrast to the theoretical models often taught in academic settings. He emphasized that a systematic approach involves quantifying intuitive linkages between economic factors and asset classes. For instance, understanding that higher-than-expected inflation might lead to rising bond yields is a simple linkage that can be quantified by analyzing the pressures on inflation relative to market pricing.
"All systemization is, 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, he argued, is a significant advantage over discretionary investing, where incremental information can lead to overreactions or underreactions. Systematization helps synthesize vast amounts of data and execute strategies with unwavering discipline.
The Nuances of Macroeconomic Forecasting and Market Bets
The discussion delved into the complexities of macroeconomic forecasting, particularly in the context of how market participants react to events. Elliott acknowledged that predicting market movements with perfect accuracy is impossible. Instead, the goal of a systematic approach is to gain an edge in predicting the behavior of various market participants.
"The idea of bringing a systematic approach to the world is to say, let me get edge in predicting what the various people involved in the markets will do," he explained. This predictive edge is not necessarily about a five-year outlook but rather understanding the motivations and likely actions of economic actors within shorter timeframes. He cited the Federal Reserve as an example, noting that their actions are a function of incoming data and a constrained set of decision rules. By understanding these inputs and response functions, one can better predict their behavior.
The concept of "bets" was central to understanding macro investing. Elliott defined a trade not just by the probability of a certain outcome but also by its pricing relative to the collective wisdom of the market. This implies identifying mispricings where market expectations diverge from a more informed assessment. This is akin to identifying situations where "Browns fans are betting with their heart, not with their head," leading to a potential market mispricing of probabilities.
Executing these "bets" involves a range of financial instruments, including futures, swaps, options, and direct buying and selling of cash securities. Hedge funds, by their nature, possess the flexibility to operate across a wide array of assets and to take both long and short positions, offering a broad spectrum of tools to express investment views.
Accessibility and Performance in the Hedge Fund Industry
Historically, hedge funds were primarily accessible to large institutional investors such as pension funds and sovereign wealth funds. However, over the past two decades, platforms like iCapital have increased accessibility for smaller-scale investors. Despite this, Elliott highlighted a significant bifurcation in the industry. The most sophisticated and successful funds often remain exclusive to institutions, not due to regulatory restrictions for smaller investors, but because they can only absorb a limited amount of capital. This creates a challenge for individual investors and smaller family offices, who may face negative selection bias or be unable to access the top-tier managers.
In 2022, the hedge fund industry, as a whole, demonstrated resilience in a challenging market environment where the traditional 60/40 portfolio experienced significant drawdowns. While the 60/40 portfolio might have been down between 15% and 20%, aggregate hedge fund performance, before fees, was relatively flat, down only one or two percent. Even strategies like equity long-short, which underperformed relative to cash, still delivered significant alpha compared to passive equity benchmarks, falling around 8% while benchmarks declined 15-20%.
"Hedge funds in these sorts of difficult market environments, they’re very good at preserving capital in general, right? What they do is they cut their risk, they manage, you know, they hold lower beta exposures," Elliott noted. This defensive posture, characterized by moving into value stocks and defensive opportunities, allowed many hedge funds to effectively play defense during a turbulent year.
The HFND ETF: Democratizing Hedge Fund Strategies
Despite the positive performance of hedge fund strategies in 2022, several pain points persist for many investors. These include high fees, typically ranging from 300 to 400 basis points annually, which can significantly erode net returns. Furthermore, the tax implications of traditional Limited Partnership (LP) structures, which often result in annual distributions taxed at marginal income rates, are a considerable drawback. Diversification also remains a challenge for smaller investors, who may struggle to invest in a sufficiently broad range of funds without incurring additional fees through fund-of-funds structures. The sheer volume of paperwork associated with alternative investments further complicates the process for both investors and financial advisors.
In response to these challenges, Unlimited launched the HFND Multi-Strategy Return Tracker ETF. The fund’s objective is to create a portfolio with return characteristics that mirror the gross-of-fees returns of the hedge fund industry, while aiming to outperform net of fees due to its significantly lower expense ratio.
"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 emphasized. HFND aims to achieve this by leveraging modern machine learning techniques to replicate the strategies of hedge fund managers in near real-time. By analyzing the positions and exposures of hedge funds, the ETF translates this understanding into long and short positions in various index products, all packaged within an accessible ETF wrapper.
This approach allows HFND to offer a diversified portfolio that aims to replicate hedge fund strategies at approximately a quarter of the management fee charged by traditional hedge funds. Moreover, its ETF structure provides enhanced tax efficiency compared to traditional LP structures, and it eliminates the substantial paperwork associated with alternative investments.
The Future of Alternative Investments: ETFs and Fee Rationalization
The emergence of actively managed ETFs, particularly in the alternative strategies space, marks a significant evolution in the investment landscape. Elliott believes that regulatory changes, which have introduced more robust risk controls for sophisticated strategies within the ETF wrapper, are paving the way for the next generation of investment products. The ETF structure itself offers inherent advantages: liquidity, transparency, tax efficiency, and ease of execution, all of which are highly desirable for investors.
Elliott anticipates a rationalization of fees across the investment management industry in the coming years, driven by a macroeconomic environment characterized by the end of the era of cheap money. This shift will place a greater emphasis on the actual skill of an investor relative to the fees they charge.
"There are absolutely hedge funds that deserve the fees that they charge. You know, they generate unique and differentiated alpha," Elliott acknowledged. However, he stressed that these highly exclusive managers are largely inaccessible to the majority of investors. For the broader market, a "reckoning" is likely to occur, where many hedge funds may struggle to justify their fees in the face of more cost-effective and tax-efficient alternatives.
The growth of sophisticated replication strategies, particularly within ETF structures, is poised to benefit investors immensely. These products offer access to complex investment strategies in a diversified, more consistent, and significantly lower-cost package compared to traditional hedge fund investments. This trend is not about replacing traditional hedge funds entirely but rather about providing investors with more choices and fostering a competitive environment that drives greater value for the end investor.
UnlimitedFunds.com is the primary source for more information on the HFND ETF and ongoing commentary from the firm. Bob Elliott also maintains an active presence on Twitter (@BobEUnlimited), where he shares insights on macroeconomic trends and investment topics.
