DIY multi-strategy hedge funds

Jefferies recently released its annual “State of Our Union”, which is about hedge funds rather than politics (yeah we don’t get it either). It contained a fascinating nugget on the rise and rise of multi-strategy hedge funds.

“Multistrats” basically combine a lot of different hedge fund strategies under one roof, and manage risk centrally. Powered by the success of the likes of Citadel and Millennium (technically “multi-manager” multistrats where each trading pod works almost autonomously) it’s been one of the hedge fund industry’s hottest corners in recent years.

In 2022 investors yanked $111bn out of hedge funds as a whole, but multistrat was one of only two strategies that still enjoyed inflows, according to eVestment (and most of the top firms in the space are actually closed to new investors).

That leaves multistrats on the cusp of overtaking long-short equity as the single biggest hedge fund strategy:

This is having knock-on effects throughout the broader industry, thanks to the wild money that the top multistrats can pay people.

The Jefferies team noted how some hedge funds were telling them that they were having problems hiring portfolio managers and analysts because of the “runaway growth of multi-manager shops”. Moreover, some star traders who would in the past have struck out on their own are instead happy to operate with the semi-autonomy that the model entails.

Multi-strategy, multi-manager firms based around the ‘pod’ model have become increasingly attractive destinations for portfolio managers and traders, typically in lieu of starting their own firms.

You can read the full report here.

But for investors, the biggest problem is that most of the top multistrats are closed to new investors, and even if you’re lucky enough to be in one, you’re charged dearly for the privilege.

In lieu of charging investors a management fee, some multistrats like Citadel simply pass on every single expense to their investors. This “pass-through” fee — which covers all salaries, technology, data and even office rents and the staff canteen — can often come to 3-10 per cent of assets a year (on top of the 20-30 per cent of any profits they take).

Investors are grudgingly willing because of the returns the top players have regularly produced. For instance, here’s FT Alphaville’s tally of Citadel’s net returns since its inception in 1991. Aside from a near-death shocker in 2008 they’ve been insane.

Others simply charge an eye-watering amount of performance fees. DE Shaw, for example, last year jacked up the performance fees on its three main funds by 5 percentage points. That means its flagship fund charges a fixed 3 per cent a year management fee, and 35 per cent of all profits it makes.

However, Jefferies noted that a “notable portion” of money raised in the hedge fund industry last year came into separately managed accounts, rather than traditional funds.

Historically, using SMAs has been more normal when seeding a new hedge fund, but “more recently, this style of investment structure has matured into a solution that serves a wide range of needs for both investors and managers”, Jefferies noted. And this has led to an intriguing development:

Make Your Own Multi-Strat?

Given the rise and growth in multi-manager shops, which averaged +6% performance in 2022, investors, via SMA platforms, are strategically creating ‘in-house’ multi-manager shops through separately managed accounts with various hedge fund managers. While the SMA model is not a fit for every manager, in 2023 it’s worth exploring the potential business scaling opportunities.

FTAV has argued before that multistrats/multi-managers are basically a new and improved fund-of-funds model, but the problem is that there isn’t enough capacity for new investor money among the top firms.

Jefferies is saying that some investors (probably bigger and hopefully more sophisticated ones) are now basically setting up DIY multi-managers by making SMA investments in a bunch of smaller, specialised hedge fund managers.

On one hand, this makes sense as a partial fix to the problem of limited capacity and high fees. The transparency is a lot better, and an investor can also design something a bit more bespoke. Here’s Jefferies on the pros of SMAs:

However, it’s also easy to see how this can go catastrophically wrong.

Managing a DIY multistrat fund through SMAs must be phenomenally complicated, and require a level of sophisticated risk management and tactical capital allocation that’s beyond most institutional investors.

Multistrats also use a LOT of leverage to juice their returns, but this is managed and watched extremely closely centrally. There have long been concerns that one of the bigger firms — or second-tier multistrats desperate to look good but lacking the risk systems and discipline of a Citadel or Millennium — might screw up and cause havoc.

If a big institutional investor tries to do the same, well, then watch out.