Agent of Wealth Episode 149 – How Investors Can Build High Quality Diversified Portfolios With Bob Elliott

In this episode of The Agent of Wealth Podcast, host Marc Bautis is joined by Bob Elliott, the CEO and Chief Investment Officer at Unlimited Funds, a startup ETF company making diversified, low cost index ETFs available to every investor. Its first product, the HFND ETF, is one of the fastest growing actively managed independent ETF launches of the last few years.

In this episode, you will learn:

What led Bob Elliott to becoming the CEO of Unlimited Funds.
Everything you need to know about Unlimited Funds’ first product, the HFND ETF.
The benefits of diversification.
Strategies investors can employ to diversify their portfolio.
Takeaways from the current market conditions.
And more!

Resources:

Disclosure: The transcript below has been lightly edited for clarity and content. It is not a direct transcription of the full conversation, which can be listened to above.

Welcome back to The Agent of Wealth Podcast, this is your host Marc Bautis. On today’s show, I brought on a special guest, Bob Elliott. Bob is the CEO and Chief Investment Officer at Unlimited Funds, a startup ETF company making diversified, low cost index ETFs available to every investor. Its first product, the HFND ETF, is one of the fastest growing actively managed independent ETF launches of the last few years. Bob, welcome to the show.

Thanks for having me, Marc.

In looking at your background, I saw that you spent nearly 15 years working at Bridgewater Associates – which, for listeners who may not know, is the world’s largest hedge fund. Can you talk a bit about your time there, and touch on how you transitioned from that role to your current role as the CEO of Unlimited Funds?

What Led Bob Elliott to Becoming the CEO of Unlimited Funds

When I started at Bridgewater in the early 2000s, it was really a challenger organization in the markets – which is hard to believe now that it’s the incumbent and really premised on this basic idea that you could use systematic rules and decision making to trade macroeconomic environments and markets. And that at the time, macro in the early 2000s was really the realm of the savants, right? The Soros’ who would bet on, make large speculative bets in macro markets. And this idea of using systemization rules based decision making in order to understand what was most likely to transpire really was novel. I was part of the small handful of investors that helped build the decision making rules as well as the company at large over the course of that 15 years going from being the challenger with a few billion dollars under management to being the incumbent.

For me, it was a very formative experience. I got a deep understanding of how the hedge fund industry works, how you develop hedge fund strategies in a rigorous and systematic way and really sort of set the stage to then do what we’re doing now at Unlimited, which is to use a combination of our decades of experience creating hedge fund strategies, proprietary hedge fund strategies with modern machine learning approaches to look over the shoulder of hedge fund managers and see what they’re doing in close to real time and then take that understanding and translate it into positions that back our ETF. Without that experience having built the strategies inside one of the most sophisticated institutions in the world, I wouldn’t have the understanding and perspective to be able to take that and create the technology that now makes those sorts of risk return profiles available out there in the rest of the world with our ETF.

You mentioned the Chief Investment Officer of Bridgewater was Ray Dalio. Dalio wrote a well-known book called Principles, which I’ve read. In it, he argues that life, management, economics and investing can all be systemized into rules and understood like machines. All in all, there’s somewhere between 100-200 different principles, so it’s definitely a lengthy book.

In it, he outlined a five-step process you can use to systematize decision-making, which can obviously be applied to investments, but you can also apply it to anything in life. Throughout the book, you really see how these so-called principles are applicable to all situations.

So you took some of the things you learned and worked on at Bridgewater Associates and eventually created Unlimited Funds. How did Unlimited Funds come about, and what led the company to creating the HFND ETF?

Unlimited Funds’ HFND ETF

My years in the 2&20 industry were both at Bridgewater and running a $125 million venture capital fund, which systematically identified opportunities using big data. Throughout that experience, I came to understand how those businesses are very good for the managers, but not that great for the investors.

The managers are actually quite good at generating differentiated returns – as you’d expect, given the amount of effort and skill that goes into it – but they’re also very good at charging extraordinarily high fees for those differentiated returns.

What ends up happening is that the investors in those products end up not that much better off than they would be on their own.

That got me to thinking hard about whether there was a way to bring the low cost diversified indexing approach, which obviously has totally changed stock and bond investing for the better for the vast majority of investors… Could we take that idea and bring it to the world of two and 20? The trouble with that is that most of the solutions that are out there on the market, which are about democratizing access or about getting a diversified portfolio of managers, they have key problems, which is that they almost always have negative selection bias, which is … And that’s because the best funds won’t take everybody’s money. And they also create a fee layer on top of the fees that the managers are already charging. Our thought was instead of trying to invest directly in the funds themselves, what if we could use our experience and our understanding of how these managers operate and build a technology that looks at what they’re doing in close to real time through the lens of their returns information, compares that to what exposures they plausibly could have on at any point in time?

Then basically solves for what portfolio best describes what’s driving their recent returns. The idea being basically, instead of star PMs, we’re using technology to understand what they’re doing and so we can offer it at a lower fee structure than what a typical two and 20 manager offers. And what we can do is we can create a diversified portfolio which includes the best funds because we can see their returns. Then the last thing is by putting it in the ETF wrapper, we can make it accessible to everyone. Every investor, even if you’ve got 20 bucks, you can get access to a diversified set of hedge fund like returns with a single share. Making that accessible to everyone is a critical part of the whole story. That’s really what HFND is all about is that idea of a diversified low cost index replication ETF which is available to everyone

And how are you getting access to seeing what the hedge funds are doing? Because a lot of times what you hear is a hedge fund is this black box, they have the secret sauce, no one can go in and see what’s going on and you basically can invest in it and we’ll send you a statement every quarter and whatever happens behind the scenes, no one knows except us.

Yeah, one of the good things is the vast, vast majority of funds report their returns, some on a daily basis and then basically all the funds report their returns on a monthly basis. That’s actually really useful. We don’t have to wait quarters to see what’s happening. We actually see what performance looks like for these funds in pretty close to real time. I just put out a tweet and a blog post recently which showed what happened in hedge fund performance last week in fact. We actually have a pretty good timely sense of what’s going on through looking at their returns.

The key that we’re bringing to the table is you can’t just look at the returns. You have to understand how those funds generate those returns. And that’s really where our skill and experience, my partner Bruce and I, us combined have decades of experience building proprietary strategies at world class hedge funds. We know what goes into those strategies. We know the types of positions and considerations that managers are using at any point in time. We use that understanding with that very timely performance information to solve for what portfolio we think best describes the returns that we’re seeing in close to real time.

You’re basically kind of taking the returns, reconstructing the portfolio from the returns?

That’s exactly right. And this can sound very black boxy, but if you’re in this business, you’ll see returns and if you look at those returns and you compare them to what’s happening in markets, you can basically infer what’s going on. I’ll give you a perfect example. The first half of 2022 global macro managers had lights out period twice as good as any other other six month period as they’d had in the last 25 years. We know they had good returns in that period. Well, what happened to asset markets in that period? Well, we know bonds sold off. We know that short rates sold off. We know that commodities rose and we know that stocks declined.

Okay, so how could macro managers have generated the sort of returns that we’re seeing in the market? Well, they must have had a combination of those positions which ultimately drove those returns. That’s really what we’re doing. We’re taking that intuition. And of course any month you could look at the returns, you could see the asset markets, you can know what sort of positions various fund managers are holding and you can sort of intuit what’s going on. All we’re doing is we’re bringing a level of sophistication and systemization to that process that goes beyond just sort of our gut intuition to something that is a little more rigorous, leveraging modern computing power and computational strategies.

As you mentioned, HFND ETF is a way for investors to get access to diversification. Why do you like diversification, and why add diversification to the ETF?

The Benefits of Diversification

Well, diversification is the only free lunch in investment. Because if you can put together a set of different returns, some of which perform well certain periods, some of which perform less well at different periods and can offset different asset returns, assuming they go up over time, you can create a more consistent return stream. Just think about why so many people hold a combination of stocks and bonds in their portfolio. I mean, in general, maybe not last year as much, but in general, stocks and bonds both go up over time and they often offset each other during various economic environments. It makes sense to put them together because the two together create more consistent return stream than each one on their own. The interesting thing that you can think about if you think about hedge fund managers and what hedge fund managers are doing is they are creating strategies that beat the market.

That idea is called alpha. The idea of returns that are in excess or differentiated from the market, that’s called alpha. And you can think about alpha in the same way as you think about normal asset returns, which is these various managers and these various fund styles, all of them you would expect to earn alpha, create alpha over time, differentiated performance relative to index investing over time. But at any one point in time, some managers may be doing better, some managers may be doing worse, some fund styles may be doing better or worse, like equity long short did very well for a few years and gold macro didn’t do very well. Then in 2022 it flipped, right? But they all perform over time.

They’re all positively performing. What you can do, in the same way you think about balancing stocks and bonds, you can think about balancing hedge fund style strategies like global macro or fixed income arm or equity long short. And if you package those together, you get a much more consistent return stream than relying on any one manager or any one fund style. What I like to call it is, I like to call it diversified alpha, right? In the same way you create a diversified asset portfolio, you can also create a diversified alpha portfolio. And that’s much better, much more consistent than any one particular manager who even great managers are going to underperform close to 50% of the time.

How active is the fund? Or is it something you’re trading daily?

Yeah, if you think about what we’re doing, we’re trying to understand the wisdom of the crowd, so to speak, because the idea here is to create a portfolio which reflects the positioning of the aggregate hedge fund industry across a bunch of different fund styles. When you look at one of those fund styles, for instance, what you see is that people’s thinking, managers thinking certainly in aggregate evolves over moderately long periods of time. Let’s take equity long short managers, coming out of COVID they were pretty bullish on tech stocks and bearish on retail. And that made sense given the macroeconomic environment. Then roll forward 18 months coming into 2022, they started to ease back their positions on tech stocks as they became more expensive. The macroeconomic cycle started to get later and pressures for The Fed to tighten started to emerge. That’s a very typical example, which is it takes 12 to 18 months for this thinking to evolve and the positioning to evolve. And that is essentially what happens with the fund itself, which is it reflects the evolution of this thinking over those typical timeframes,

Were you worried at all that the open reporting of the ETF could lead to investors copying the strategy?

Well, the first thing that we started with when considering which wrapper to put this product in and the strategy in was what’s the best product for the investor? And it’s unambiguous that ETFs are the best product for the investor. The reason why that is that they’re tax efficient. Well, this isn’t tax advice, in general, if you hold an ETF for at least a year, you only pay taxes when you sell the asset and you typically would pay capital gains except for any dividends along the way. It’s a more tax efficient structure, it’s also more liquid, right? ETFs have the ability, you can trade intraday if you want, and you can trade it on an exchange. You don’t need to deal with getting into or out of a mutual fund and certainly much more efficient than an LP type structure. The other thing which you highlight is transparency.

Now transparency goes both ways. Part of what we’re doing is we’re showing everyone what positions we have on. Now that is somewhat helpful to others though just direct replicating it is not necessarily that great because first of all, you don’t know where we’re going with our positions, so you don’t actually understand what the strategies are. And second of all, if you take it outside the ETF wrapper and you say run it in an SMA, you lose a lot of the tax efficiency of it. Because the nice thing about the ETF is you can have a multi-asset portfolio that’s rebalancing and can wash the capital gains in the structure so that the investor doesn’t see the capital gains and losses. You would lose those efficiencies. Then I think on the other side, what’s the benefit? There is no ambiguity about what we’re doing.

You go to UnlimitedETFs.com to download our holdings and look at what we’re doing. That way, you can judge for yourself whether it makes sense for your strategy as an investor.

The credibility that you get from that with advisors and investors is just so much better than if you’re in a mutual fund structure or LP structure where it’s pretty ambiguous what you’re doing. How often are advisors, I mean, I hold mutual funds or LP position sitting there going, “What are these people doing? I have no idea.” Versus that’s the beautiful thing about the ETF structure is you know what’s going on? There’s no ambiguity. And even though people might replicate what we’re doing in one way, shape, or form, I would much rather have a structure where investors can see what we’re doing very clearly with that transparency and judge for themselves whether they think it makes sense, than hide the positions behind obfuscation that exists in mutual funds or LP structures.

What is the ETF benchmarked against?

The fund itself is focused on generating total returns. As written in the prospectus, there is no specific index that we’re benchmarking against.

That said, we’re running our technology against to generate the views that we are. And what we’re doing there is we have constructed our own index of the gross of fees returns, meaning the returns before you take out the fees of the hedge fund industry. And that is what we’re using technology to understand what the positions are and what’s driving their returns. Now to be clear, the gross of fees returns of the hedge fund industry is not an investible asset. If you can invest in it, if you find the ability to invest in all hedge funds on a gross of fee basis, you should invest in that all day long.

We’ve set ourselves up for a benchmark that is not an investible benchmark and a very high hurdle rate. That gross of fees, benchmark gross fees of hedge fund return benchmark through time over the last 25 years returns a hundred basis points better than the S&P 500 with half the monthly volatility and a third of the draw downs. That is quite a high hurdle. And really what we’re trying to do is we’re trying to deliver returns that are equivalent to the hedge fund industry, but because we’re charging lower fees, right? Because we’re charging 95 basis point management fee rather than two and 20, we expect the ETF to outperform reported hedge fund industry returns, net of fees.

That’s what we’re trying to do. There’s a number of different reports that you can look at on that front. Barclay Hedge or HFRI or Credit Suisse, a number of different … Bloomberg for those folks who might have Bloomberg, has an index as well. They’re all pretty close to the same. There’s some nuances that I won’t bore people with, but you could look at those indexes and you could basically say, “Is this product doing better or worse than those reported indexes?” To be clear there, those are reported net of fees. Our goal is to beat those net of fees reports.

You’ve mentioned 2&20 quite a bit, can you explain what that fee model is?

How the 2 and 20 Hedge Fund Fee Structure Works

Sure. 2&20 is a shorthand description of the typical fee structure that you see in a number of asset managers, both hedge fund managers as well as private equity and venture capital and others. And what that refers to is typically managers will charge a fixed fee each year of 2% of the assets under management that they’re managing, and then they’ll charge 20% of the returns of the fund, the positive returns of the fund. That’s sort of the two and 20 idea. As an example, if you just think about that from the perspective of let’s just say a 10% returning fund before fees, what that means is that those funds would typically take 2% from that 10% right off the top.

You go from 10 to eight, and then they typically take 20% of the returns of that eight, so you’d lose another 1.6. The net of fees returns of that 10% returning vehicle would be something like 6.4% or something like that. If you look at that as an example, if you just think about these days cash is returning … What’s cash returning? Four and a half or five? If you think about the returns above cash, what you get as an investor is like 150 basis points, 1.5%, and the manager above cash is getting paid 3.6%, right?

Right, yeah.

That is the problem. I mean, if you were getting 10% returns, that’d be pretty good in the scheme of things, particularly given the volatility and the drawdown profile of those returns. But if the manager’s getting 3.6% and you’re getting 1.4, that highlights that there’s a fee problem, the problem is the fees, the problem is not the strategies, the problem is the fees.

And I think the other thing, going back to your decision to put this in an ETF wrapper that we maybe talked about a little bit, but it’s the liquidity too. I think I see a lot of times where people will invest enough, a fund or some kind of private equity or hedge fund and for whatever reason they don’t like it, they need the money. They don’t realize that in that 60 page document that they signed, it says you don’t have access to your money or you may have access, but you have to give a six months notice or something like that where the ETF, you don’t like it, you can sell it the next day or that day or at any point. I think that is an important feature of ETFs versus when you talk about some kind of private fund.

Exactly, exactly. I like to say that we have to earn our keep every single day because every single day an investor can look at what we’re doing and just sell it. That makes it harder for us and better for the investor. And I think that’s a great thing. Why shouldn’t investors be able to get access to their capital when they want it? And I think we’ve talked a lot about HFND and our hedge fund replication, which is our first product, but some of the other things that we’re working on are private equity and venture capital replications, where the illiquidity is very extreme. I mean, many investors I talk to today who invested in venture funds over the course of the last couple years turn to me and say, “I know that it’s going to be tough sledding for venture funds and private equity over the next couple of years because of the macroeconomic environment and because of the valuations that those investments went into.”

But I can’t do anything about it. Imagine you’re holding a fund, imagine you’re holding a venture fund or a private equity fund and you think that it’s going to go down 70% and there’s literally nothing you can do about it because your money is locked up. It’s locked up for as much as 10 years. And while it’s going down like that, recognize that the manager, regardless of the outcome is getting paid. He’s getting paid to deliver a poor return regardless of whether or not it’s a good return or a bad return, the manager gets paid.

He’s making money, yeah.

And that just isn’t right.

Why Target Date Funds Suck

Yeah. Now, let’s shift the conversation a bit… You produce some great content on your website. Two articles stood out. The first one is Only Stocks for The Long Run? Why Target Date Funds Suck. Why is that your opinion? And can you summarize that concept to the listeners?

Yeah, I mean, a lot of the 401(k) infrastructure that exists today is dominated by a small handful of players that are basically push investors and plan participants into these target date funds. The trouble with these target date funds is that the way that they’re allocated is highly concentrated and incredibly imprudent. The reason why that is because frankly these funds were set up just to basically take 401(k) capital in and put it into a combination of stocks and bonds. And that was the level of sophistication that was easy for Vanguard and others to run. They actually charge reasonably high fees in the scheme of things for these products given what they’re offering. And it’s a pretty good business for them. The problem is, if you think about how those target date funds are structured, let’s say even someone who is, let’s say, close to retirement, those funds may have 50% of the capital in stocks and the only diversifier that they might have is bonds.

And those bonds are of short duration, low volatility. If you look at the returns of those funds or those target date funds over time, they’re structured in a way that 95% of the return is driven by the returns of the stock market. The stock market, to be clear, it’s very valuable to invest in stocks and certainly the history in the US is that the stock market has gone up very well and delivered a good real return, which is what you care about as a saver, over the course of the last 120 years. But that doesn’t mean it always does. And in fact, if you look over the course of the last a hundred years, there’s been three periods where stocks have had a drawdown of roughly 15 years. Well, if you retire at the beginning of that 15 years and you have to face a stock drawdown over that period, it can meaningfully impact your retirement.

And that’s what I worry about today is we’re late cycle. We’re in a tightening dynamic. What happens if stocks go down 20 or 30 or 40%? I’m not calling for that right here, but I’m saying that is a set of risks that as a saver you have to be prepared for. And do you have in your 401(k) the sort of assets that will do well in those environments so that you’re not stuck in such a substantial drawdown and have to either delay or change your retirement? What I argue in that piece is to look for other assets that create improved diversification in order to create a more consistent return.

And those assets are, for instance, buying longer duration or longer term treasuries, which offset stock performance. Looking for real bonds tips, which are actually quite pretty attractive these days, particularly for late savers, given the fact that they offer 150 basis points of real return guaranteed. If you hold the bonds to maturity, you get 150 basis points of real return, which if you’re a late saver, that is actually pretty darn good all things considered. Then of course, other assets that protect you against inflation like gold and commodities are also in prudent sizes in a portfolio can be beneficial as well.

Is the U.S. Economy Really Headed for a Recession?

The other article I found interesting was titled, Is The U.S. Economy in a Recession? Recession concerns and recently, the bank crisis, are top-of-mind for most investors. In your opinion, is the U.S. economy in a recession? Do you see the economy heading into a recession?

The U.S. economy is not in a recession. In that article, whwe look at the data, NBER, which is the National Bureau of Economic Research, which is sort of the official agency that calls recessions eventually, we just look at the data that they’re looking at when they assess whether an economy is in recession. Now they do it almost always after the fact. What we’re doing is we’re looking at that data in real time to see whether or not their decision, whether they would decide based upon the information. Taking a step back, if you look at the economy, the economy has been quite resilient over the course of the last 18 months of this Fed tightening cycle. If you look at demand, consumption by households, it remains relatively strong, particularly nominal terms, employment remains pretty good, unemployment is at secular lows, at 50 year lows, payrolls are growing well.

Really the only place in the economy that has been softer of late has been a bit of weakening in housing activity and a bit of weaker manufacturing activity. But those are early in the cycle, typically the first sort of couple of things to slow down in a macroeconomic cycle and in a typical macroeconomic cycle, it can take a year or two from the point of those parts of the economy slowing down to a point where we start to see a broader slowing of economic activity and we’re basically following that normal path tightening in response to a hot economy. It takes a few years for that economy to slow down because the US economy, I think is best thought of, it’s like a big tanker ship, it’s moving in a direction and it’s hard to slow down a big tanker ship and The Fed is throwing anchors overboard, right? Hoping to slow it down, but it takes a while for the economy to slow down.

That’s exactly what we’re seeing is there’s still a fair amount of momentum in the economy. Now, 12 months from now, 18 months, 24 months from now, probably we will see a slowing of economic activity. And I think it’s important to recognize in the context of asset markets, what’s priced in. Whenever you think about assets, you have to think about what’s priced into the economy, what’s priced into the asset markets versus what’s likely to transpire? There, I think the biggest concerns that exist are in the equity market where we’ve had a selloff in equities from a peak of 15%, let’s say, give or take, from the peak level, entering 2022. Most of that has been as a function of the rise of bond yields. In many ways, the earning side of the picture for the stock market hasn’t really changed that much, has actually gone up, not down over the course of this period.

And if you think about that compared to what you see in typical recessions, typical recessions, earnings fall, let’s just say 20-25%, currently they’re not priced to fall at all. That’s a real gap in terms of how equity markets are priced. If we are, I think it’s probable that we’re on this path to eventually get to a recession, if you look at how stocks are priced, they’re not priced that way. That really is the concern for the average investor. This is actually a great opportunity to take a moment, look at your risk, see how much equity risk you have, see whether you can find less equity risk to look to other assets like long dated bonds, real bonds tips could be a good opportunity here. Or look at gold and commodities as portfolio diversifiers in the event that inflation is stickier than we expect.

This is a great opportunity to do that.

I know we talked today about cash… it’s not a bad asset. Typically, you pay a penalty to hold cash, because the yield is not that great. But these days, cash is yielding 5%, so the penalty to holding cash is very low. I think there’s no shame in taking capital out of equities and moving it into cash during a late cycle environment.

Now of course, it’s not going to make for a good cocktail party conversation, “Oh, I’ve really got a great T-Bill fund for you to look at.” But it’s prudent money management.

Yeah, that definitely makes sense. Alright, we’re just about out of time. Bob, thank you for joining me today – you provided some great information on investing and the markets. How best can our listeners find out more about you, or about Unlimited Funds?

You can go to unlimitedfunds.com, which is our advisor site and has the blog we spoke about, as well as information about our products. Then also if you’re interested in what’s going on in the macro economy, I run an active Twitter account. You can find me at @BobEUnlimited. Definitely check that out if you want a day-to-day view into what’s happening.

Great, we’ll link to all that in the show notes. Bob, thanks again for being on The Agent of Wealth. And thank you to everyone who tuned into today’s episode. Don’t forget to follow The Agent of Wealth on the platform you listen from and leave us a review on the show.

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