“Hedge funds don’t have a strategy problem, they have a fee problem”

Institutional investors have a reputation for outsized returns. But are their high fees justified? Bob Elliott is on a mission to change that. The former right-hand man of Ray Dalio has set up his own investment firm to launch an AI-powered fund with the aim of replicating hedge fund strategies, at a fraction of the price.

These days, Elliott runs asset management firm Unlimited Funds, which he co-founded in February 2022. The firm uses machine learning and big data to replicate hedge fund strategies, but without the industry standard two-and-20 fee structure (whereby funds charge a basic 2% management fee plus a 20% performance-related fee on profits above a certain threshold). Instead, the firm aims to offer its funds at a far cheaper, 95-basis-point management cost.

His mission is simple: offer the benefits of institutional-level market returns to a wider audience of investors, and demystify the sometimes opaque world of hedge fund management in the process. The Unlimited HFND Multi-Strategy Return Tracker ETF [HFND] is the firm’s flagship fund. It works by allocating exposure to a basket of exchange-traded funds as well as fixed-income assets such as cash to create a portfolio that is similar to the industry’s returns. 

Elliott’s background is broad as it is impressive. He enjoyed a spell at consumer fintech firm CircleUp as head of venture capital, as well as a stint at biotech company Roivant Sciences [ROIV], where he was head of innovation and chief business officer. At Bridgewater, he wrote the widely read Daily Observations newsletter and advised leading policymakers on market economics and investment issues. More recently, he has appeared as a commentator on broadcast channels including CNBC. 

And when Ellliott speaks, people tend to take notice, including when he recently proclaimed that “the era of cheap money is over”. Today, Elliott’s approach is all about leveraging systematic, rules-based strategies to make intelligent investment decisions. In essence, it boils down to “managing money in a disciplined and effective way”. 

Here, Opto learns about how the New York-based investor got started in investing, why hedge funds have a fee problem and how Unlimited Funds aims to change that, as well as his outlook for markets in 2023. 

My academic training was mostly as a pure scientist in botany. The scientific approach, in many ways, is about systematics. That way of thinking is highly applicable to [how investors view] the macro economy and markets, [which are] complex systems that are evolving over time. I love botany and I still garden, but I realised being a research scientist wasn’t what I wanted to do with my career. I was drawn to macroeconomics in particular because it helped me understand how the world works, my place and set of actions in the context of the overall world and how people interact in their daily lives. Even to this day that’s a big driver of why I find it so interesting.

When I started at Bridgewater, the concept of systematic macro was novel. Macro was the world of the savants like George Soros [billionaire investor and co-founder of the Quantum Fund] speculating on the pound. What I helped to do — over the 15 years [I was there] — was move away from that and instead take a fundamental understanding of the macro economy and translate that into logical rules to invest in a way that is diversified and highly disciplined. That was innovative 20 years ago and has now become, for many investors in the macro space, commonplace. It helped me build that foundation of how you use systematic thinking to improve decision making. Whether that’s building a systematic commercialisation approach to pharmaceuticals, which I did at Roivant, or leveraging big data to improve decision making around which consumer companies to invest in, which I did at CircleUp. Or what I’m doing now, which is leveraging a systematic approach to understand how hedge funds are positioned at any point in time. 

Lots of hedge fund managers more than justify the fees they are charging. They invest billions of dollars a year in order to develop and maintain edge in financial markets. My guess is that will probably persist over time. The greater challenge is for those managers who aren’t justifying their two-and-20 fees. An imperfect but pretty good replication of what they are doing could easily outcompete them at a much lower cost. I suspect what we’re going to see is a rationalisation of managers over the next 10 to 20 years, and a consolidation to a smaller set of better managers who justify the fees they are charging. Hedge funds on a gross fee [basis] were down in 2022. But it’s important to see this in the context of, essentially, the worst performance of financial assets in 100 years. They delivered significant alpha in an extraordinary market environment. If you asked most investors, if they came out of 2022 close to flat, people would have been happy as a clam.

Hedge fund strategies offer a spectrum of levels of sophistication. Index investing is at one end. Simple factor-based investing and smart beta concepts, for example, are in between. [At the other end] sophisticated alpha managers draw on a range of approaches to consistently generate better returns than index investing. The traditional distinction between retail and institutional investing has been a matter of access, not strategy. Frankly, retail investors haven’t been able to get access to sophisticated hedge fund strategies partly due to regulatory constraints and partly because the funds themselves didn’t want to engage a retail client base. 

Hedge funds don’t have a strategy problem, they have a fee problem. There’s a very simple reason why a technology-enabled ETF can outperform hedge fund investing, and that’s because the fees are a lot lower. We can charge a 95-basis-point management fee, instead of two-and-20. Most hedge fund economics are built on two-and-20 fees, and have been for decades. There’s obviously been some amount of fee pressure over time, but we’re talking moving closer to 1.5 and 15, and that has taken 30 years. If anything, some of the indications looking forward are that the best funds are raising fees, through a variety of methods, including charging expenses to investors. Some of the biggest multi-strategy funds are charging seven-and-30 or worse, and locking up their clients’ capital for three to five years. The main question is, will the managers’ strategies justify fees at that rate? That is uncertain. That’s why one of the most durable alphas you can have is fee alpha: making it cheaper to implement a strategy than others. That serves as the foundation for what we are doing. 

The core idea for Unlimited is to give all investors access to the most sophisticated strategies. What we’re trying to do, through the use of technology and a better fund structure, is make that available to all investors, [to ensure] they have a broader range of opportunities beyond just index or simple factor-based investing. I haven’t heard a good reason why the everyday investors shouldn’t have their money managed just as well as the world’s largest institutions. If anything, it’s more important, because there’s more on the line for them. What’s great is we are increasingly entering a world where the differences between passive, beta collecting risk premiums, alpha and active are becoming more explicit to investors. Products from the likes of Vanguard and BlackRock really [cater to] this, saying: ‘this is an index fund that collects risk premiums and generates returns on this index’. When you’re looking at alpha products, that’s a good benchmark as you have to do something meaningfully different to what the index is providing.

HFND is an aggregation of using technology intended to replicate all the underlying main hedge fund sub-strategies. We’re looking to launch those sub-strategies and make them available, probably by the end of the year. We’re also working on replications of other two-and-20 asset classes including private equity and venture capital, which we expect to launch sometime in the near future as well. 

The reality is making money in markets is very hard. If you haven’t been in the trenches and seen the good, the bad and the ugly, you won’t have the humility to know what you’re doing could be wrong or what you’re missing. You can’t have technologists with no investment experience creating technology to invest money in a way that can reliably create outcomes because they haven’t been through the humility of their trades, systematic approaches and strategies going painfully wrong. Until you’ve been through that process you can’t reliably craft a way to manage money.

The most interesting theme we’re seeing at a big-picture level is significant uncertainty. We have a very unusual cycle right now. It’s important to remain conservatively positioned through it, given the uncertainties You generally see managers tilted towards the US and the global economy, remaining in the late-cycle dynamic with continued moderately good economic conditions. Elevated inflation is requiring a continued tightening of monetary policy, so we see managers positioned underweight duration. They are holding fewer bonds and stocks than they typically would. Stock holdings are tilted away from US mega-cap stocks and towards value away from growth. That is very indicative of a late economic cycle tightening environment.

As we enter a world where money is no longer easy and inflationary pressures are persistent, it’s going to take skill to generate alpha. We were listening to Britney Spears [in the mid-90s] the last time [monetary policy] was tight. The vast majority of investors today grew up and had careers in environments where disinflation was persistent and money was easy. We are transitioning to a world where disinflation and easy money are no longer going to be present. Where inflationary pressures are likely to be more durable and money tighter. That has a real effect on investing in assets of all kinds. As we shift to an era of tighter money, it’s not a great time for asset returns. Within asset markets, say equity or credit, tighter money advantages those businesses that aren’t reliant on borrowing in order to maintain or expand cash flow and profits. Investors need to turn attention away from the high beta-peddlers to more sophisticated alpha investors — that’s the big shift we’ll see over the next decade.

As an investor today, I’d be thinking very carefully about whether I have enough coverage in case inflation gets higher than expected. A diversified portfolio of commodities or gold are both assets that are chronically under owned. But both bonds and stocks will probably not do well in an environment where inflation is meaningfully higher. Whenever I bring gold up as an important asset in a portfolio, people look at me like I’m a crazy person. Because most investors have only seen disinflationary periods, they underrate assets that protect them from persistent inflation. Gold has outperformed stocks over several different timeframes in 25 years*. It has provided a better hedge than bonds in about half of the equity market downturns in the last 100 years. But it’s a boring asset. We can’t really talk about the nuances of the next technology or product that gold is offering. It’s a yellow rock that sits in a bowl. But it works, that’s the reality. We’ve got to get the portfolio that best protects us in the event we have an inflationary dynamic.

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