Ascendance of the Pod Masters

Multi-manager, multi-strategy hedge fund platforms (also known as “pod shops”) are receiving a lot of attention these days from asset owners, the media, and asset managers who compete with them.  Good performance, huge paydays, and perceived scarcity will do that.

As with every episode like this, one has to ask how far and how fast the trend will go — and whether heightened expectations, bigger pools of assets, and more favorable terms (for the managers) will sow the seeds of disappointment to come (for investors).

A superior approach?

In brief, the fund platforms aggregate money and then dole it out to scores, even hundreds, of portfolio management teams — the pods.  Each has a defined strategy and risk limits in which it operates.  Assets are allocated to the pods based upon the desired mix of exposures for the fund overall and on recent performance.

In a sense the “human capital” is rented and disposable in a way that is unusual at most asset management organizations.  (It is somewhat akin to how big investment banks work, where specialized trading desks or entire businesses can spring up or go away quickly depending on what’s hot and what’s not.)  The composition of the investment team, if you want to call it that, can change in meaningful ways in a short period of time, something that would normally turn off asset owners.

So the organization really boils down to its leadership and the framework that exists to add and subtract those moving parts, to provide the operating environment and the risk management to monitor them, and to allocate assets.

Is it a superior approach?  Can (and should) it be adopted in other parts of the investment business?

Strong demand

As noted in a good Bloomberg article by Nishant Kumar, “Almost all the new money in hedge funds is going to giant multi-strategy investments.”  As ever, performance has driven the flows, as the big firms structured in this way have delivered steady (if not spectacular) numbers over many years, with small drawdowns and moderate correlations to equities.  Those results and the “emphasis on rigor” in pulling capital away from underperforming pods,

appeals to pension funds, foundations and endowments that have gravitated toward hedge funds, often without the resources to closely track what each manager’s doing.  When the rest of the investment community opts for diversified multi-strats, why get on the rollercoaster with a rockstar?

Those investors (and ones not mentioned) are eager to add more money to the few firms that fit the bill.  No doubt other asset managers will try to meet the demand by copying the category leaders, but they will struggle to compete with the incumbents, which are of a size and profitability that they can continue to invest (in systems and pod talent) and innovate (as Citadel has done with weather-related strategies) to stay ahead of the crowd.

Risks

Which is not to say that there aren’t risks involved in investing with them.

Regime shifts ~ While the firms have demonstrated the ability to adjust quickly to new environments, changes in established relationships and correlations (which we’ve had quite a number of in the last few years) present opportunities to stumble.  Market history is replete with examples of expectations based on statistics and trends going awry.

Scale ~ Those shifts can be most painful after a period of success, when the assets of an individual firm or a group of like funds chasing a winning approach get too large and the pile of assets under management becomes unwieldy.

Leverage ~ Returns are better with leverage until they’re not — and those willing to supply that leverage have shown time and again that they aren’t very good at pulling it back in advance of problems developing.  How likely are they to turn down the opportunity for more business with these headline-grabbing managers?

Put these three things together and you have to wonder about the scenario brought up by Will Potts in the Bloomberg article:

Could you imagine the Fed allowing a $50 billion multi-strategy hedge fund to fail?  I can’t.  Think about the pain that Archegos caused and that was tiny in comparison.  The damage that would be done to the prime brokers would cause financial distortions, it would be LTCM on speed.

And there is the “war for talent” which the success of the platforms is engendering.  (Among the many reports of that phenomenon, see “The State of our Union 2023: RESET,” from Jefferies, and articles in the New York Times recently and the Financial Times in late 2021.)  At what point does paying a lot for talent become paying too much for talent?

The view from the pods

The chief beneficiaries of that war for talent are the people who can get enormous up-front guarantees, but everyone who stays in the pod system benefits from the largesse.

There are other advantages to being a pod person rather than taking the traditional route of hanging out your shingle as the leader of a startup.  You don’t have to deal with the hassles of regulatory requirements or operations or marketing or investor relations — and maybe you’ll be able to attract a better team around you at a pod shop than if you were running your own firm.

You can get on to the business of investing, and do so faster and in a bigger way, as Andrew Beer told Bloomberg:

Joining a multi-strat on Monday and having $500 million to punt around on Tuesday is a hell of lot more appealing than scrounging for $50 million of seed capital to start your own firm.

There is a flip side, of course.  You are now the rented and disposable human capital previously described.  All of the advantages cited above can go away in a hurry.

Bloomberg again:

Multi-strats, meanwhile, have a low tolerance for underperformance.  With individual managers less visible to clients, those who start losing in high single digits or overextend their risk can have their assets cut at best, and at worst can be fired on the spot.

It’s not unusual to see a tweet from someone on the wrong end of the whip who was blown out for their individual work or because their whole pod was jettisoned.  Many me-too comments from others in response commiserate about similar experiences and life in the pod jungle.

As mentioned before, that’s a different look than what you’ll find in many parts of the business, although it apparently doesn’t stop firms from talking about the strength of the teams they assemble as if they are the key to their long-term success.  For example, this is from Citadel’s website:

To maximize our impact, we’ve built a team-first culture that always seeks a better idea — then works to make it a reality.  Working and learning together, we create new solutions that reveal market opportunities.

According to published reports, during a few months in 2021, 13 of 27 portfolio managers at Citadel’s Surveyor unit were axed, while ten new ones joined, a level of turnover that seems to not fit very well with the narrative.

Fees and other terms

A recent posting on this site asked the question, “Are hedge funds aligned with their investors?”  Certainly the question applies to these platforms, since they have been the most aggressive in pushing for higher fees and other favorable terms, especially when it comes to passing through the expenses of their operations to their investors.

That’s how the war for talent translates into costs for investors.  Historically, hedge funds charged 2% a year on account balances and 20% of the total return produced in a year (with a high-water mark in place so that a performance fee isn’t earned until a drawdown is recouped).  The AIMA report cited in the previous posting documents the declines over time in the average levels for each of those fees — until recently, when they ticked up, driven by the multi-strategy platforms.

The report also addresses the pass-through fees, which can turn a 2% fee on assets (when the managers are paying the operating expenses themselves) into an effective fee of 6-10% or more, according to published estimates.  Given that war for talent, those numbers may be going even higher, illustrating why firms are willing to so aggressively wage that war.  Someone else is paying for it.

Some of the firms also charge performance fees that are notably higher than 20% and, increasingly, lockups of investor capital for five or ten years are part of the deal too.

Alignment issues everywhere you look.

It has long been a part of the pitch from the managers of hedge funds — and those who favor investing in them — that the size of the fees doesn’t matter, that it’s the net return that does.

But in most areas of the investment world, higher fees are generally correlated with worse performance.  Net return is an aspirational concept.  Fees, on the other hand, are going to get charged no matter what (although the pass-through approach has made pinning down the amount of them more difficult).  So high fees can matter for the future, even if they haven’t seemed to in the past.

However, another Bloomberg article, “Hedge Funds That Charge Most Tend to Perform Best, Barclays Study Shows,” provides some (limited) ammunition for the net-return case.  Of 290 funds, the worst performance was for those funds without any pass-through fees.  Those with partial pass-throughs did much better, and the ones with a full pass-through of fees topped them all.  The time period was only three and a half years, but that was enough for Roark Stahler of Barclays to say:

Established multi-strategy managers, with a strong brand, have the ability to hire the best talent, purchase the most data and invest in infrastructure.  Those costs are passed on to the investor, which benefits the firm, but also shows investors should be OK paying that because they’re still getting better returns even after those fees.

Ecosystem effects

Any trend like this causes ripple effects in the investment ecosystem.  That war for talent is a big one, increasing costs for hedge fund firms that don’t pass expenses along, as well as for other asset managers whose analysts and portfolio managers are at risk of getting poached.

As assets increase at the platforms, certain strategies might get more competitive, putting previously assumed alpha at risk.  There will likely be fewer emerging managers — and a more challenging fundraising environment for those that do give it a go, since their survivability may be viewed as less likely.

A Financial Times piece from Robin Wigglesworth considers the prospects of “DIY multi-strategy hedge funds,” while asking the question, “What could possibly go wrong?”  It references the Jefferies report cited earlier, which says

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.

But Wigglesworth writes that it’s “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.

On another front, for those wearing due diligence hats, the challenge will be trying to understand how the platforms work when there is limited visibility into them.  Especially since your co-workers and clients/stakeholders may be pushing you for opinions on them (and often wanting to hear particular answers).

For starters:  How are decisions made at the strategic level?  What is the role of qualitative analysis versus quantitative analysis in the allocation process?  What does risk management entail besides clipping the wings of underperformers?  How are teams selected?  What kinds of resources are they given?  Is there any attempt at developing them, or is it just survival of the fittest?  Is any information shared between them or are they walled off from each other?  (Speaking of information, how can the potential use of inside information, which is arguably more probable in this kind of firm, be monitored and prohibited?)

And, a fundamental question for asset owners:  Is there an imaginative approach to analyzing these organizations and the pods that comprise them or is the “work” going to consist mostly of an evaluation of performance?

Next steps

Existing investors in the pod shops no doubt are pleased with the performance that they’ve received and with the emotional satisfaction of “being in on” the most talked-about (and written-about) strategy around.

It seems that only one thing will break that allegiance now; investors quoted in articles about the firms say they will stay the course as long as the outperformance continues.  According to the AIMA report, despite the tougher terms from the multi-manager firms, clients “are prepared to accept [them] provided that the same managers continue to deliver performance that meets their expectations.”

The rest of us might want to think about whether we would invest with the pod masters if given the chance to do so; whether their methods should cause us to rethink how organizations are structured and strategies are managed; and what the broader implications of this industry development might be.