Illiquid Alternatives: Fishing in a Smaller Pond

This research note is produced by Elkstone in conjunction with our hedge fund and cta manager database partner, Nilsson Hedge.

  • In our view, hedge funds are not an asset class; they are an investment vehicle which can be utilised to bring in return streams that are unrelated, diversifying, and alpha generating.
  • We operate within the ‘family office investment universe’ which is forced to be overlooked by institutional investors. This universe provides significant investor advantages.
  • We screen out the most common hedge fund strategies and concentrate on small, inefficient markets and unique price movements across different markets and geographies.

Hedge funds can be a misunderstood investment tool. Hedge funds are not an asset class; they are an investment vehicle with pre-agreed terms and conditions across strategies, markets, fees, and liquidity terms. Below is the typical structure of a hedge fund, which is nothing more than a company set up to trade bound by its company’s offering memorandum/prospectus:

In the early 2000’s, based on their performance success, the hedge fund industry became institutionalised with large investors joining the party. This started the significant increase in AUM and therefore requirements for allocation. We believe that this been a catalyst to the investor inefficiency that drives the most common hedge fund strategies’ underperformance of late.

It would not be surprising if the average investor believes that hedge funds are a poor investment choice. This statement can be argued for and against, however, this statement is far too general as it’s usually tied to the performance of the most covered strategies and by the most covered managers.

An investor saying ‘I have a $10 million allocation to hedge funds’ means nothing. It matters what strategies, markets and risks drive your hedge fund returns. This short note delves into hedge funds in more detail and touches upon our internal hedge fund views and portfolio.


As we always look at what we are getting from both a market/strategy and investment vehicle, we understand that with a hedge fund investment, we will and can get the following:

Cost: Historically, an industry standard of 2&20. However, that average is down closer to 1&20 currently. There are some still at the traditional level.

Liquidity: It differs, but the standard is a 1-year lock-up with quarterly redemptions.

Management: Active management.

Market Coverage: Can trade one, or more, of hundreds of different markets.

Strategy Coverage: Can trade one, or more, of hundreds of different strategies.

Trade Setup: Can trade one, or more, of hundreds of different trade setups.


The ‘lost decade’ for hedge funds. It is no secret that the average hedge fund has underperformed over the past decade. We believe that has been driven by the structural change of institutional involvement bringing with them inefficiencies in the investment process – we touch on this in the next section.

The biggest return challenge coming from the structural inefficiency can be summed up by ‘AUM attracts AUM’. This means that large funds keep getting larger. Due to the sheer volume that the large managers need to put to work, they start becoming aligned with the traditional markets as they must only go into extremely high-capacity strategies and high-capacity markets. With a natural alignment to the traditional markets, beating their benchmark during the bull run of the past decade has proven to be a challenge to say the least. Most have not overcome this challenge which has led to fee pressure and negative news headlines for the industry.

Institutions are struggling to find alpha and a reason to remain invested within the hedge fund space. Family offices are however able to fish in a different hedge fund pond where there should always be a place for a hedge fund portfolio.


Internally, we refer to a ‘family office investment universe’; we define this as the universe of strategies, markets and managers that sit below the high minimum threshold that institutional investors must adhere to. Large advisors, wealth managers and funds themselves that invest for institutional investors must adhere to the parameters that are put on them. You’ll find that advisors, wealth managers and funds tend to only consider hedge funds that manage at least $500 million in AUM and strategies that must be able to take at least $1 billion in AUM. These players are therefore forced to overlook any manager that sits below those AUM thresholds.

The high minimum capacity threshold is a function of resources, return impact and risk management. With thousands of funds out there, allocators cannot spend significant time analysing and conducting ongoing due diligence across the entire investment universe. Funds that close at smaller AUM levels do not move the needle enough to warrant resources – a $200 million fund making 20% would mean that $40 million profit was made, however $40 million does not move the needle for a fund that is managing $10+ billion AUM. From a risk perspective, an investor does not want to be a large percentage of the investor base. As it is not uncommon for institutional investors to write $50+ million cheques and it is not uncommon that an institution does not want to be more than 10% of the investor base, they are forced to only look at funds with minimum $500 million in AUM.

This institutional investor inefficiency’s major effect is that the already large managers are the only managers that pass institutional investment screens which causes large managers to get even larger. This creates a disproportionate gap between manager AUM levels without even considering manager performance or return drivers. There are small, strong performing managers that are alpha generating and diversifying who are forced to be overlooked. These managers continue to exist only in the ‘family office investment universe’ and are therefore only accessible to non-institutional investors like family offices. This is where Elkstone and our co-investors can thrive.


The family office investment universe sounds like a nice differentiator, but how does this translate in terms of an actual investment impact. It allows us to execute on two areas:

  1.  only pay hedge fund fees for a return stream that provides us with a return that is fundamentally and wholly unrelated to the rest of our portfolio and
  2. adding difficult to reach portfolio diversification and alpha.

In order to execute on our investment philosophy, we have to find and invest in managers that are able to isolate their return streams on market inefficiencies and idiosyncratic risk (unique price movements). We argue that market inefficiencies and unique price movements are inherently capacity constrained. Due to the capacity constrained nature of them, they all exist within the family office investment universe and are difficult to find in the investment universe that institutional investors operate within which is where the media coverage tends to exist.

Let’s take the S&P 500 as an example. This is a portfolio of 500 individual companies. Let’s also say that you can only invest $1 into any individual company. This means that if the current S&P500 momentum moves the index from 4000 to 5000, you can make 25% on a $500 investment. This is a beta/market-wide movement. Let’s say during this time, one of the 500 companies goes bankrupt; this is a unique price movement that doesn’t affect the other 499 companies. If a hedge fund manager can isolate their return on this unique price movement only, they are providing alpha and diversification, but they can only put $1 to work. If this manager becomes very large in terms of AUM because of their alpha and diversifying historical returns capturing unique price movements, they now must put $5 or $10 to work instead of just $1. They may still capture future bankruptcy events, but they can only put $1 to work in that company and therefore still have $4 or $9 following the rest of the market. This will lead to significant overlapping exposure with the rest of the portfolio which makes it very difficult to outperform on an after-fee basis.

We look to find the managers that only put that $1 to work across different strategies and markets.


Our internal hedge fund portfolio tends to be quite differentiated from the hedge fund strategies the media covers. Why? Because what gets talked about within investment media tends to be around the large funds that are set up for institutional investors. The traditional strategies that everyone associates with hedge funds tend to be screened out by us. Two examples include Global Macro and Equity Long/Short that has a net long exposure. We screen out Macro Global because there is significant overlap with the rest of our portfolio; we already have exposure across the traditional asset classes for cheaper than hedge fund fees and we don’t believe that any manager can consistently call the right direction within the markets they operate within. When we look at our whole portfolio, it is in essence its own global macro portfolio. We want to use our hedge fund allocation to achieve something far more targeted that has no overlap with the rest of our portfolio. We screen out directional Equity Long/Short because once again there is significant overlap with the broad equity markets which we already have exposure to for cheaper than the hedge fund fees.

We look for capacity constrained managers that are utilizing the hedge fund vehicle to bring us in an unrelated return stream that we can’t get elsewhere within our portfolio. We’ll use the copper market as an example of what we look for within our hedge fund portfolio. If we want exposure to the copper market, we can get that by using a copper market ETF which will cost us about 25 basis points (¼ of 1%). If copper moves from $10,000/Tonne to $12,000/Tonne, we capture this 20% move for 25 basis points. If we are considering a hedge fund manager that operates within the copper market, they must provide us a return stream that we don’t already have exposure to from our copper ETF.  There is a well-known copper exchange arbitrage between the LME and COMEX exchanges. This is an exchange price spread that separates for fundamental reasons and, importantly, comes back due to fundamental reasons. If we use a hedge fund to only capture this exchange spread within the copper market, they are buying and selling copper at the same time, therefore not being exposed to that $10,000 to $12,000 move, and only isolating their return on the exchange spread. This is not a return stream we can get from an ETF and both copper investments are fundamentally unrelated – when comparing the exchange spread return versus the copper market return, there is about a 7% correlation. The exchange spread is capacity constrained and is a fundamental inefficiency within the copper market. These are the types of strategies and return streams we look to capture within our hedge fund portfolio.

Our hedge fund portfolio looks after our entire hedge fund allocation across all asset classes. Relative to our 6-block internal portfolio, our hedge fund portfolio sits below:


With our internal investment team having previously traded niche, inefficient markets, we understand that these unrelated return streams exist within the ‘family office investment universe’ and how they work. By utilizing the differentiating characteristics of a hedge fund vehicle relative to the less expensive peers and by concentrating in an over-looked and under-invested corner of the hedge fund industry, we believe that there is always a place for a targeted hedge fund portfolio, regardless of what stage of a market cycle we are in.


Illiquid Equities: Stock Picking in the Private Markets

Liquid Alternatives: Traditional Commodities

Liquid Debt: Active or Passive?


Karl Rogers is the Chief Investment Officer of Elkstone Private. Elkstone is a family office managing the wealth of its principals, with a focus on real estate, venture and alternatives, and a Multi-Family Office, regulated by the Central Bank of Ireland, which provides both access to co-investing in our principals’ investment portfolios and traditional family office services to many of Ireland’s entrepreneurs and HNWIs. Previously to Elkstone, Karl was a Managing Partner with Athlon Family Office, Head of US Power Trading with RISQ, Managing Director of ACE Capital Investments, a hedge fund manager and a proprietary commodity trader.

Karl currently sits in the adjunct faculty for Trinity College Dublin’s M.Sc. in Finance program where he is both a guest lecturer in their alternative investment module and supervises the student’s theses and he is a Special Advisor to the ESG Foundation.

Karl has been referenced in major industry publications including the Wall Street Journal, Bloomberg and the Financial Times and has spoken at numerous family office and alternative investment conferences across multiple continents.

Connect with Karl on LinkedIn.


Elkstone is a Family Office managing the wealth of its principals, with a focus on Real Estate, Venture and Alternatives, and a Multi-Family Office, regulated by the Central Bank of Ireland, which provides both access to co-investing in our principal’s investment portfolios and traditional family office services to many of Ireland’s entrepreneurs and HNWIs.