However, over the past year, multi-PM assets have dropped by about 10% from USD 369 million to USD 366 billion, which implies somewhat larger gross outflows of assets despite their continuing positive investment performance.
The first half of 2024 saw net outflows of USD 31 billion, two thirds of which, FERI estimates, were investor-led redemptions. Some of these funds also periodically make compulsory redemptions and return capital to investors when they approach or hit capacity limits.
Consistent outperformance
Some of this asset growth has come from the compounding effect of strong performance year after year, and not only from net inflows from investors. The ‘Magnificent Ten’ multi-PM firms have outperformed other multi-PM managers and hedge fund managers in general, almost as impressively as the Mag7 mega cap tech names have outpaced US equities. The top ten pod shops have achieved annualized returns of 13%, net of fees.
Risk-adjusted returns have been extraordinarily consistent. Since June 2019, an index of the top 10 multi-strategy funds has generated a Sharpe ratio approaching 3, more than triple that of the HFRX index, which has also had a worst drawdown four times as large. The Magnificent Ten have captured 70% of world equity market returns with less than 20% of the volatility.
Of course, any index of multi-PM managers has lower volatility than the individual managers due to diversification benefits amongst them. It nonetheless produces an almost suspiciously straight line of returns, which may remind some investors of Madoff, but this time the numbers are real!
Trading costs and leverage costs
The returns are magnified by substantial leverage. The top ten firms use an average leverage of 8.5x, significantly more than in smaller multi-manager firms, and consequently manage gross assets of USD 2.2 trillion. They make up just under 10% of hedge fund industry net assets but are now a much larger proportion of gross assets since most other managers are less leveraged. This scale of assets and share of the hedge fund market may raise concerns about potentially increased market impact and transaction costs when trading. There could also be concerns about the costs of leverage since interest rates have normalized and are expected to stay above zero for many years.
Fees and costs
The Magnificent Ten all have a pass-through cost model, charging rents, salaries and other operating costs to investors. Median pass-through costs have reached 5% per year. In addition, pod team bonuses are passed through to investors without any netting amongst teams, which results in an effective performance fee of 15-30%, which is higher than the headline performance fee levels for most hedge funds.
Rising talent costs
These firms are some of the largest employers in the hedge fund industry: Millennium has over 5,000 staff, while Citadel and Point72 each have nearly 3,000. Balyasny is close to 2,000 and Brevan Howard around 1,000. Each firm could have 150-200 portfolio managers all trading independently of the others in pods, and the firms may be trading as many as 15 or 16 or more strategies.
The war for talent is not only between pod shops. They are also competing with tech giants such as Apple and Google and others in Silicon Valley. First year pay packages are reportedly exceeding USD 20 million for some individuals and even interns can earn as much as USD 25,000 per month.
Net returns count
Theoretically, if two firms deliver the same gross investment returns, the one with a pass-through fee structure would deliver lower net returns to investors since costs and fees consume a higher share of gross performance. In practice, as mentioned, firms with pass-through fee structures have delivered much higher net returns, which means that their gross returns have been even further ahead of the rest of the industry.
Longer liquidity terms
Most hedge funds offer monthly or lower levels of liquidity, but the multi-PM shops are locking up investors for increasingly longer periods.
Though the pod shops reportedly trade liquid strategies, only 24% of these funds could now be exited within a year, 48% would take over one year, 18% over two years and 10% now require over three years to fully redeem capital. Investor-level gates are one way to slow down redemptions. They typically restrict redemptions to 25% per investor per quarter and in contrast to the ad hoc freezes imposed in the GFC, this is advertised in advance.
One perception is that they may now need longer notice periods because strict risk limits make them the first sellers in a correction or crisis, and larger assets mean they are selling a higher proportion of daily or weekly or monthly liquidity. Therefore, they might need to slow down the pace of redemptions and portfolio liquidations because in a fire sale situation such as the GFC they would fetch lower prices. And any crowding into the same positions increases the potential market impact of a synchronized sale.
Diversification by positions and risk factors
Though the multi-PM shops seem riskier in terms of leverage, they may be less risky on other risk measures. Pod shops are subject to very strict risk limits on equity market beta, style and factor exposures, as well as position sizes. These risk controls are all strictly enforced: portfolio managers and entire teams at the multi-PM firms can often be immediately fired for breaching risk or loss limits. Traditional discretionary hedge fund managers run much more concentrated portfolios with larger individual positions and wider risk tolerance.
Pure alpha returns
The returns are not only independent of equity and bond beta but are also independent of other well-known styles and factors. The return profile appears to be genuine, pure and idiosyncratic alpha. Even FERI’s sophisticated non-linear factor decomposition cannot explain the returns.
It is undeniable that the net returns to investors are excellent even after the high fees, and the idiosyncratic nature of the return pattern provides a strong diversification benefit for portfolios. Time will tell if this level of alpha generation proves to be sustainable with much larger amounts of assets, higher costs of leverage, and higher staff costs.
A global search for hedge funds
FERI scours the globe for hedge fund talent and holds no bias to large US multi-strategy managers. Managers presenting at previous FERI Hedge Fund Days have come from ten cities in Europe, nine in North America, three in South America, four in Asia, and one in each of the Middle East and South Africa.
Given the macroeconomic backdrop of interest rates and inflation, FERI expects that long/short equity will be a valuable part of portfolios. Equity market valuations are historically high, particularly in technology, and hedge fund managers have often been short of more expensive parts of the equity market. Market neutral and often sector specialist stock-picking strategies form the core of many multi-strategy, multi-PM funds, but these alpha streams can also be accessed in other hedge funds.