Leading hedge funds have the capability to deliver enormous returns for investors, but their active management comes at a price. Bob Elliott, CEO at Unlimited, joins the show to discuss HFND’s unique alternative strategy, and why he believes alternative ETFs have the potential to outperform hedge funds, net of fees.
The world of alternative investments, particularly hedge funds, has long been synonymous with the potential for outsized returns, often outperforming traditional markets. However, this allure comes with significant barriers to entry, including high fees, complex structures, and limited accessibility. In a recent discussion on The Alternative Investment Podcast, Bob Elliott, CEO of Unlimited Funds, articulated a vision for democratizing access to sophisticated investment strategies through the innovative use of Exchange Traded Funds (ETFs), directly challenging the traditional hedge fund model.
The Hedge Fund Landscape: A History of Exclusivity and High Costs
Hedge funds, by their very nature, operate outside the regulatory confines of mutual funds, allowing for greater flexibility in investment strategies, including short selling, leverage, and derivatives. This adaptability, coupled with active management by highly skilled professionals, has historically enabled them to navigate volatile markets and generate alpha.
Bob Elliott, with nearly 15 years of experience at Bridgewater Associates, a pioneer in systematic macro investing, brings a deep understanding of these complex strategies. He explained that his early career was shaped by the realization that rigorous, systematic approaches could be applied to macroeconomics, moving beyond the realm of "savant" investors. This experience instilled in him a profound appreciation for how the global economy functions and how to systematically identify and capitalize on its intricate linkages.
"The macroeconomy works very differently than what you’d learn in a college macroeconomics class or what a traditional academic finance education would give you," Elliott stated. He emphasized that the key lies in understanding the intuitive cause-and-effect drivers and then quantifying these linkages to build disciplined, systematic investment strategies. This approach, he noted, offers a significant edge over discretionary investing, which can be susceptible to emotional biases and overreactions to incremental news.
However, the traditional hedge fund model presents several significant challenges for investors. Elliott highlighted the exorbitant fees, typically ranging from 300 to 400 basis points annually, which can significantly erode investor returns. He pointed out that while hedge fund strategies themselves often outperform traditional benchmarks like the S&P 500, the high costs can negate this advantage, leaving investors with net returns that are not substantially better than passive alternatives.
Beyond fees, tax inefficiency is a major hurdle. Traditional Limited Partnership (LP) structures often result in annual distributions taxed at high marginal income tax rates, impacting an investor’s after-tax returns. Furthermore, diversification within the hedge fund space is a significant challenge for smaller investors. Access to the most successful and sought-after funds is often restricted to large institutional investors and ultra-high-net-worth individuals. For smaller investors, gaining diversified exposure typically involves investing in funds of funds, which adds another layer of fees, further diminishing potential returns. Finally, the sheer volume of paperwork associated with alternative investments, including K-1s and extensive subscription documents, creates a significant administrative burden for both investors and financial advisors.
2022: A Year of Vindication for Alternatives, But Not Without Nuance
The year 2022 presented a challenging environment for traditional investment portfolios. The widely followed 60/40 stock-bond portfolio experienced significant drawdowns, with estimates ranging from 15% to 20% losses. This backdrop significantly boosted the appeal of alternative investments, which demonstrated resilience and, in some cases, strong performance.
Elliott noted that the hedge fund industry, as a whole, performed commendably in 2022, largely achieving flat to slightly negative returns before fees. This performance is particularly impressive when contrasted with the steep losses in traditional markets. Even equity long-short strategies, often criticized in the media, delivered an estimated thousand basis points of alpha relative to passive equity benchmarks, highlighting their capital preservation capabilities.
"Hedge funds in these sorts of difficult market environments, they’re very good at preserving capital in general," Elliott explained. He attributed this to their ability to manage risk, reduce beta exposures, and identify value opportunities during periods of market stress. This defensive positioning underscores the inherent value proposition of active management in alternative strategies during turbulent economic conditions.
Unlimited Funds’ HFND ETF: A Disruptive Innovation
In response to these persistent challenges within the hedge fund industry, Unlimited Funds launched the HFND Multi-Strategy Return Tracker ETF (HFND). This actively managed ETF aims to provide investors with exposure to hedge fund-like return characteristics, but with significantly lower costs, greater tax efficiency, and enhanced accessibility.
"What we thought was, was there a way to bring the kind of low-cost diversified indexing approach, which has obviously totally changed stock and bond investing, right? Was there a way to sort of take that concept and apply it to the world of two and 20?" Elliott queried. The solution, he detailed, lies in leveraging advanced machine learning techniques and proprietary hedge fund strategies to replicate the gross-of-fees returns of the hedge fund industry.
The core of HFND’s strategy involves using technology to "look over the shoulder" of hedge fund managers, identifying their positions and exposures in near real-time. This information is then translated into long and short positions in various index products, packaged within the ETF wrapper. This approach allows Unlimited Funds to offer a diversified portfolio with return characteristics similar to the hedge fund industry, but at a fraction of the management fee.
"Because we’re using technology rather than, frankly, star PMs that you have to pay millions and millions of dollars. We can offer it at, you know, about a quarter of the management fee that a typical hedge fund would charge," Elliott stated. Furthermore, the ETF structure itself offers significant tax advantages over traditional LP structures, making it approximately twice as tax-efficient.
The HFND ETF also addresses the diversification and accessibility issues. As an ETF, it has no minimum investment requirement, allowing investors to purchase even a single share. This democratizes access to sophisticated strategies that were previously out of reach for many retail and smaller institutional investors. The liquidity and transparency inherent in the ETF structure also provide a significant advantage over the often cumbersome redemption processes of traditional hedge funds.
The Future of Alternative Investments: A Shift Towards Efficiency
Elliott believes that the ETF structure is fundamentally more investor-friendly due to its liquidity, transparency, tax efficiency, and ease of execution. Recent regulatory evolutions, which have enabled managers to run more sophisticated strategies within ETFs while implementing robust risk controls, have further paved the way for this transition.
He anticipates a significant rationalization of fees across the investment management industry in the coming years, particularly in the wake of the end of the era of cheap money. As market returns are expected to moderate, the focus will shift squarely to the net-of-fee performance and the actual skill demonstrated by investors.
"There are absolutely hedge funds that deserve the fees that they charge," Elliott conceded. "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 for the vast majority of investors."
For the broader segment of the hedge fund industry that may not justify its high fees in the current economic climate, Elliott foresees a significant shift. He predicts that capital will increasingly flow towards more sophisticated replication strategies offered in investor-friendly structures like ETFs. This trend, he argues, will ultimately benefit investors by providing access to diversified, consistent, and lower-cost investment strategies that were previously unavailable or prohibitively expensive.
The emergence of products like the HFND ETF represents a pivotal moment in the evolution of alternative investments. By leveraging technology and innovative structures, Unlimited Funds is challenging the status quo, aiming to deliver the potential of hedge fund-like returns to a much wider audience, thereby democratizing access to sophisticated investment strategies and pushing the entire industry towards greater efficiency and investor alignment.
