Leading hedge funds have historically offered the potential for substantial investor returns, but their actively managed, often opaque strategies come with significant costs and accessibility challenges. Bob Elliott, CEO of Unlimited Funds, recently discussed his firm’s unique approach to providing alternative investment strategies through an Exchange Traded Fund (ETF), HFND, arguing that alternative ETFs have the potential to outperform traditional hedge funds on a net-of-fees basis. This development signals a growing trend of making sophisticated investment strategies more accessible and cost-effective for a broader range of investors.
The Hedge Fund Landscape: Promises and Pitfalls
The term "hedge fund" often evokes an image of exclusive, high-performing investment vehicles, a notion that has captivated investors for decades. These funds, characterized by their flexible investment mandates and use of diverse strategies, including short selling and leverage, aim to generate alpha – returns above a benchmark – and often provide diversification benefits. Historically, hedge funds have been the domain of institutional investors and ultra-high-net-worth individuals, owing to high minimum investment requirements and complex regulatory structures.
Bob Elliott, with nearly 15 years of experience at Bridgewater Associates, one of the world’s largest hedge funds, brings a deep understanding of systematic macro investing to Unlimited Funds. His early career involved developing and implementing systematic investment strategies across various asset classes, gaining insights into the intricate workings of global economies and financial markets. Bridgewater’s innovation lay in applying rigorous, systematic approaches, typically seen in strategies like equity long-short, to the complex world of macro investing, moving it from the realm of intuition-based savants to a more quantifiable discipline.
"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 explained. He emphasized that developing a true understanding involves recognizing the intuitive cause-and-effect drivers within asset classes and then quantifying these linkages. Systematic investing, at its core, is the quantification and repeated application of these understandings in a disciplined manner. This discipline is crucial, as discretionary investors can often be swayed by incremental information, leading to overreactions or underreactions. Systematic approaches offer a framework to synthesize diverse information and execute strategies as designed.
Elliott illustrated the probabilistic nature of even the most successful macro investing: "Even the best macro investors in the world are wrong about 45% of their bets in any one month. But if you do that, if you have the coin on your side, 55-45, and you flip it, you trade 100 markets, that gives you a little bit of edge." This edge, when applied consistently over time, can lead to exceptional investment performance, akin to a skilled blackjack player who leverages probability to their advantage.
However, the journey into hedge fund investing for the average investor has been fraught with challenges. Traditional Limited Partnership (LP) structures often involve substantial paperwork, including complex tax forms like K-1s, which can be burdensome for both investors and their financial advisors. Furthermore, the fees associated with hedge funds—typically a "2 and 20" model (2% management fee and 20% performance fee)—can significantly erode returns. For instance, in a year where the broader market, represented by a traditional 60/40 portfolio, experienced drawdowns of 15-20%, the aggregate hedge fund industry, before fees, managed to stay relatively flat, down only 1-2%. This demonstrates their capital preservation capabilities during turbulent periods. Equity long-short strategies, often criticized, still delivered approximately 1000 basis points of alpha relative to passive equity benchmarks in 2022.
The Rise of Alternative ETFs
The landscape of alternative investments is evolving, with ETFs emerging as a powerful vehicle for delivering sophisticated strategies to a wider audience. The HFND ETF, launched by Unlimited Funds, embodies this shift. Its strategy aims to replicate the gross-of-fees return characteristics of the hedge fund industry. The core thesis behind HFND is that by leveraging technology, including modern machine learning techniques, and operating within the cost-effective and tax-efficient ETF wrapper, the fund can deliver superior net-of-fees returns compared to traditional hedge funds.
"The first pain point is that hedge fund fees are very high," Elliott stated. "If you take the hedge fund industry as a whole, they’re typically adding between 300 and 400 basis points of fees on an annual basis. And what that does is it takes the returns of the strategies, which in general are actually quite good… But you add 300 to 400 basis points of fees, and investors look at something and they say, ‘Well, I’m not that much better off than I would be, you know, doing it on my own.’"
Beyond fees, tax inefficiency is another significant drawback of traditional hedge fund structures. Annual distributions from LP structures are often taxed at marginal income tax rates, which can be substantial. The HFND ETF, structured as an ETF, offers significant tax advantages, being approximately twice as tax-efficient as traditional LP structures.
Diversification also presents a hurdle for smaller investors. Gaining adequate diversification across numerous hedge funds would require substantial capital and navigating complex fund-of-fund structures, which themselves can layer on additional fees. The HFND ETF aims to provide broad diversification by replicating a portfolio of hedge fund strategies in a single, accessible product. The administrative burden of investing in traditional alternatives—the extensive paperwork and the challenge of tracking down clients for signatures—is also addressed by the ETF structure, which offers liquidity and ease of trading on major exchanges.
Machine Learning and Systematic Replication
Unlimited Funds leverages proprietary experience in developing hedge fund strategies, combined with advanced machine learning, to create its HFND ETF. This technology allows the fund to monitor hedge fund managers’ positions in near real-time, translating this understanding into long and short positions in various index products. This systematic approach to replicating hedge fund strategies aims to capture the essence of their risk-return profiles without the associated high costs and access barriers.
"We saw all those pain points that existed in the market," Elliott explained. "And what we thought was, was there a way to bring the kind of low-cost diversified indexing approach… was there a way to sort of take that concept and apply it to the world of two and 20?" The answer, for Unlimited Funds, lies in creating an ETF that utilizes their expertise and technology to replicate the gross-of-fees returns of the hedge fund industry at a fraction of the cost.
The fund’s strategy is overseen by Elliott and his partner, who bring a combined 50 years of hedge fund experience. While the process is systematic, the human oversight ensures continuous monitoring and evolution of the underlying algorithms. This blend of advanced technology and seasoned expertise is designed to provide a more consistent and beneficial outcome for investors.
The Future of Alternative ETFs
The emergence of actively managed ETFs, particularly in the alternative strategies space, represents a significant evolution in the investment industry. While early iterations of actively managed ETFs faced skepticism, a new wave, driven by regulatory advancements and investor demand for more sophisticated, accessible, and cost-effective products, is gaining momentum. These advancements, including regulatory changes in 2020-2021, have allowed managers to implement more complex strategies within the ETF wrapper, provided robust risk controls are in place.
The ETF structure itself is inherently investor-friendly, offering liquidity, transparency, tax efficiency, and ease of execution without extensive paperwork. As investors and financial advisors increasingly prioritize these attributes, the demand for alternative ETFs is expected to grow. This trend signifies a broader shift towards democratizing access to strategies previously reserved for institutional investors.
Elliott believes that the next 5 to 10 years will witness a "rationalization of fees" across the investment management industry. In an era of potentially lower returns due to the end of cheap money, the value proposition of investment strategies, relative to their costs, will come under intense scrutiny. While a select group of hedge funds generating unique alpha will likely continue to command their fees and remain accessible primarily to institutions, the broader hedge fund industry may face a reckoning.
"For the rest of the world, you know, who aren’t those big, sophisticated institutions, 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," Elliott asserted. He anticipates a bifurcation where capital flows to the most sophisticated managers, and a significant portion also moves into innovative replication strategies housed in structures like ETFs. These ETFs offer access to sophisticated investment strategies that are diversified, more consistent, and considerably lower in cost compared to historical alternatives.
The proliferation of alternative ETFs is not necessarily a direct replacement for traditional hedge funds but rather an expansion of choice for investors. For high-net-worth individuals and family offices, a combination of liquid alternatives, like hedge fund ETFs, and traditional, less liquid alternative investments can form a well-rounded portfolio. The increasing availability of these innovative products fosters competition, pressuring all asset managers to enhance value and offer the most advantageous solutions to their clients.
Unlimited Funds’ HFND ETF represents a significant step in this direction, aiming to provide investors with the potential benefits of hedge fund-like strategies through a more accessible, cost-effective, and tax-efficient structure. As the investment landscape continues to evolve, such innovations are poised to redefine how investors access and benefit from sophisticated alternative strategies.
Investors interested in learning more about Unlimited Funds and the HFND ETF can visit their website at unlimitedfunds.com. Bob Elliott also maintains an active presence on Twitter, @BobEUnlimited, where he shares commentary on macroeconomic trends and investment topics.
