From AQR Quant to Founder & CIO with Brian Hurst

25:50And so when you're running a multi-strategy fund, it's really about looking at these common risks. Beta is the simplest example. It could be sector exposure. It could be factor exposure, like momentum you mentioned earlier. And there's a lot of other less well-known, but known in the industry, risks that take place. People talk about crowding. There's reasons why crowding happens. So being able to be aware of those and look for signs of that and trying to mitigate those commonalities across your different strategies is a really key component to managing risk for these multi-strategy funds. There's so many different ways to go with this.

26:23So you're implying with these crowded funds that there's a way to identify when you're in a crowded fund. I recall the quant quake a couple of years back where all these big quant shops post-GFC really seemed like they were having the same sort of exposure and the same sort of problems. How can you identify an event like that before it takes your fund down 10%, 20 %? that? That's a great question. And I would say a more recent example might be COVID, March of 2020. So I talked about a couple of different common risks. One is beta. Another one might be factors. A simple other one is just, there's a well-known strategy.

27:09Let's say merge arbitrage. There are plenty of funds that are running merge arbitrage as one of their strategies within the fund. Simply because a lot of people are doing something that in a sense, when there is some other exogenous event that causes people to de-risk, it actually makes it bad to be in well-known, well-understood trading strategies. So that, you know ahead of time that this is something that is crowded. You know that there are other players that are doing the same kind of trades as you going in. Huh. That's really interesting. And just to put some meat on the bones, multi-strategy, multi-manager, multi-model funds have really gained prominence lately.

27:51Names like Citadel, Point72, Millennium, lots of other larger funds have very much adopted this approach. Fair statement? That's very fair. I do think it's the best way to deliver alpha. So you're reducing correlation, you're reducing risk, you're increasing the odds of about performance, how broad are firms like Citadel or Millennium that they don't run into that crowded trade risk? You would think given their size and their tens of billions of dollars, a crowded trade becomes increasingly more likely, right? Right. And there's a reason for why that's the case. There are literally thousands of different types of ways to make money in the markets, thousands.

28:35But there's only dozens of ways of making money in the markets that have lots of capacity means you put a lot of dollars in general a lot of dollars scale up to scale up and if you're going to be a very large fund you by definition have to put more and more of your money into the well-known large trading strategies and so they have to be particularly attuned to the fact that they are large and their competitors are also large and then they're same kind of trades so it is a risk and when these things you know when one of these shops sells out or reduces risks and one of these common strategies it's going to affect the other ones.

29:08It's hard to avoid that, but they are fairly well diversified across many different types of strategies. So that's what you see still very consistent returns, but there is this exogenous risk element of having being big in the credit. The way you avoid that is by being smaller, focusing on smaller strategies that are a little bit different. Really interesting. So you mentioned earlier, early days of hedge funds, the fund-to-funds were popular, it feels like they're kind of going away. You certainly hear much less about them these days. Is that a fair assessment? Just because you don't hear about stuff doesn't mean it's disappeared.

29:43But I certainly read much less about fund-to-funds. They are in the news much less. Have multi-manager, multi-strat, multi-model broad funds replaced the concept of fund-to-funds? I think it's an evolution. It doesn't mean that the fund-to-funds model is going away entirely. There's certain managers out there who have commingled vehicles that only, you know, they won't run an SMA for you. They won't trade their strategy into your account. Fund of funds can access that. So there's a reason for that. And, you know, they're nice one-stop shops and they can maybe be a little more transparent. But there are, you talked about this earlier, the fees being an issue.

30:20And it's really about the fee as a percentage of the dollars of P &L being earned. There was an academic paper recently published. They did a really interesting study over 10 years of looking at institutional hedge fund portfolios. What it showed is that for every dollar of P &L being generated by these hedge fund strategies, at the end of the day, the institutional investor took home about 37 cents. Really? Which is, I think, a shocking number for a lot of people. Right, right. So you're saying almost two-thirds of the money never, either it's fees or costs or some other factor, but only a little more than a third ends up with the actual investor.

31:01That's right. And it's really interesting. It breaks down the sources of all these things. Part of it is fees and double layers of fees and things like that. A big part of it is the behavioral nature, which I think is driven by governance of investing organizations. Filled with humans. Yes. Strategies down, what's been down, let's get out of that. Let's get into the thing that's been up recently. That costs about a third of your alpha. That doesn't surprise me at all. Even though you expect big endowments and foundations and hedge funds to be smarter than that, fill them with people and you're going to get those behavioral problems, aren't you?

31:37Yeah. Well, there's agency issues in between, and I think investors are well aware of these. So that causes part of it too. But a big thing, and I think that kind of the multi-manager, multi-strategy approach tackles that a fund of funds can't is you get a lot of netting benefits, both from one manager's long apple, another manager's short apple. In a fund of funds approach where you're investing in two different funds, well, A, they don't know that. And B, the managers who long apple, they're paying a financing spread to go leverage long apple. And the manager who's short is paying a financing spread to go short apples.

32:10A lot of costs built in. You're paying a lot of extra costs there. Just to be net flat. Just to be net flat. So if those two managers instead traded those positions into the same vehicle, you're getting that efficiency. And that's worth, you know, on the order of like 2 % to 3 % per year, just that alone. The enhanced risk management you can get by having daily position transparency and all the trades of all the different PMs are doing, being able to hedge out all these beta risks, factor risks, sector risks, things like that, allows you to be much more efficient with how you deploy that capital.

32:41And so you see that these multi-manager funds tend to be a little more invested than a hedge fund portfolio typically could be. And that creates a lot of efficiencies. And so when you look at the returns that they're generating, it's closer to like 50-50, where for every dollar that's generated at P &L, 50 cents is going to an investor. So it's a much more efficient delivery mechanism of alpha. So we were talking earlier, and I mentioned off air that the funny element of individual investors tending to underperform their own investments. I know you've done some research on that. Tell us a little bit about what you see.

33:19Yeah, this is really something that's very important to me when I think about the industry and what are the big problems that are facing the industry? What's really causing investors not to get as much money in their retirement accounts as we possibly could get there? One of them is this behavioral issue, which I think also ties to incentives and governance and agency issues within investing organizations. Morningstar does a study that they call Mind the Gap, and they do it on a regular basis. some of your listeners might have heard this and it's definitely worth reading i'll quote some numbers off the top of my head i might be remembering it incorrectly but what it does is it's measuring the time-weighted returns of funds which is the returns that the report these are the returns that if you invested a dollar at the beginning and you held it all the through the returns you would have gotten if you never went to or went out of that fund then they compare that to the asset weighted returns, right?

34:14And the asset weighted returns are counting for the fact that the fund does well, everybody gets excited, money comes in, larger assets, and then it maybe does not as well after that. And so the larger assets earn less return. And so the asset weighted return minus the time weighted return is a really good way of measuring what's the actual impact of this behavioral element of investing, which is a really critical part of investing. And the gap refers to the behavior gap, which is the difference between what the fund generates and what the actual investors are getting. Please continue. And so what you find is that for 60, 40 balanced funds, which typically are in retirement accounts, where people maybe aren't looking at them every single day, they get statements once a quarter that are delayed.

35:02Set and forget, just leave it alone for decades. It's kind of a set and forget. That gap is on the order of 60 basis points. Relatively small. Relatively small, but it costs 60 basis points a year for the average investor for those simple funds. Now for alternative funds, when they look at those, that gap is 170 basis points a year. Okay, that's starting to add up. If you think about that compounding over a decade, that is a massive hit to wealth. Why is there such a big gap for alternatives and not as much of a gap for the 60-40? I think it has a lot to do with investor understanding of what those products are and therefore the confidence.

35:38People invest in alternatives, they don't necessarily understand them. And so you're setting yourself up for failure a little bit there because when it has bad performance, you don't understand what it does. You're more likely to redeem. That makes a lot of sense. So to me, investor education, really understanding what they're investing is, is a critical component to being a successful investor. Really interesting. Interesting. So you talk a lot about idea meritocracy. It's on your site. You've written about it. Explain a little bit. What is idea meritocracy? This is a really important part, and it's a part of our culture at Clear Alpha.

36:14The idea is to get all ideas surfaced so that the organization can make the best decisions. How do you, you know, what prevents good ideas from surfacing? One is that people may not know that a question is even being asked. So many organizations are run fairly siloed, different groups. And a lot of that happens, especially at large organizations. It's hard for everybody to be constantly communicating with one another. So just not even knowing a question exists. So the way we address that is that we use Microsoft Teams at the office. And most people are in various channels. And we're seeing questions going on all the time.

36:52I really discourage people from asking me a one-on-one question. And I will usually redirect a question someone asked me to, here's the broad company. Here's the question that was asked. Here's the answer. So then immediately the entire company learns what this topic was. And very often that says, oh, someone else, I have another idea about that that I want to now share. So getting accessibility for people to deliver. But the most important about idea meritocracy is really from a leadership standpoint. People have to feel safe bringing up ideas that they're not going to get yelled at. There's no bad questions.

37:30There's only people not asking questions. That's what's bad. And the only way for people to feel safe about that is that they need to see me as the leader and my other partners as the leaders to be willing to take in feedback, be challenged even publicly, and say, you know what, that's a really good idea. Let's go with that. And so just having them feel that safe environment so that people can always ask and bring questions up. Huh, that's really interesting. Also, you've discussed generating less common ideas. Earlier, we were talking about crowded trades. How do you generate less common ideas?

38:07How do you find non-correlated sources of return when you're in a hyper-competitive marketplace? Great question. So I'll use an example here. There's a common strategy that people might be familiar with. It's called merge arbitrage. And basically, company A is going to buy company B, whether it's for cash consideration or a stock-for-stock type transaction. And merge arbitrageurs look at that, and they might go, long the company that's being acquired, short the company that's being acquired, and then make money if that deal ultimately closes. That's a very common, well-known strategy. That would be the common version of implementing the strategy.

38:45A less common version to implement is you try to find ones that you like more than others. So you might think they all are like the vast majority are going to close, but some you might like better than others. And so you could go long half of them and short half of them. So you're not exposed to this common element of merger arbitrage deals closing. You're neutral to those. So if a large pod shop, one of these large multi-managers, if they decided to get out of merger arbitrage and they're selling all these positions down, half your portfolio will get helped and half your portfolio will get hurt.

39:20But you're less exposed to that crowding risk, that common, what I would say, risk factor that these other common strategies have. So that's a niche version of how we might implement that kind of a strategy. You mentioned niche. I never heard the phrase prior to reading something you had written called niche alpha. Tell us a little bit what niche alpha is. That's a great question. The simple answer is you're unlikely to have any or much of it in your hedge fund portfolio. That's how I would describe it. And so it's looking for people that are either implementing common strategies in a very different way that makes them less susceptible or more immune to people getting out of that strategy.

40:02Or people have a completely different idea of how to make money that I haven't heard of before. And I've interviewed hundreds, if not thousands, of portfolio managers and worked with, developed many strategies of my own. So it's trying to find things that people aren't doing. Huh. Is there, given what we know about the efficient market hypothesis, and Gene Fama was Cliff Asness's doctoral advisor, or MBA advisor? Cliff was Gene's TA. Yeah. So given how mostly efficient the market is, are there really niches left that have not been discovered? How many more opportunities are out there that we don't know about?

40:42That taps into something we talked about earlier, which is there are thousands of ways to make money in the markets. There's only dozens of ways to make money in big dollar size. At scale. At scale. So these smaller ideas, is that where the mostly kind of eventually efficient market hasn't quite reached yet? Well, what I think about is the amount of dollars you can make. This is a ratio I think about. The amount of dollars you can make divided by the complexity or how much brain damage you have to inflict upon yourself to actually implement the strategy. A lot of these small strategies, they're complex and difficult to do.

41:18They might require some kind of new technique that is difficult or rare to implement. And the actual P &L that you can generate, profit and loss you can generate, is small. Fill up to that effort. Small in terms of percentage returns or small in terms of, hey, there's only$100 million to arbitrage away with this. And once that is mined, that's it. It's done. It's about dollars of P &L you can extract from the markets per year. Percentage returns can be very high for these strategies. But I'll give you a sense. Most other large shops, they're going to look for strategies that can generate at least$100 million of P &L to make it worth their while to invest.

41:57We're looking at strategies that are generating$10,$20,$30,$40 million per year. Huh, that's really kind of intriguing. So what sort of demand is there for lower capacity strategies? I mean, so you guys are less than half a billion dollars. You're not an enormous fund. Are there more hedge funds looking to swim in these ponds? Or is this something that, hey, once you cross a certain size, you just have to leave behind and stay with those larger capacity, scalable strategies? Yeah, I think this is a general thing for all investors, not just other hedge funds. Everybody wants to be in the interesting things.

42:35They want to be in the lower capacity things. They know that they're less crowded. The difficulty, and really what I think kind of our business model is, is you're paying for us to go out and search the world and source them because it's expensive. It's an expensive exercise to do. People might not have the expertise or the background to underwrite these types of strategies. It just takes a lot of work. And at the end of the day, alpha is either about being smarter or working harder. The being smarter can work in the short term, but eventually that does get out of the way. Eventually someone smart enough comes by.

43:04The working harder to me is the thing that actually stays. Huh, that's really interesting. You would think if the incentive was there, enough people would just eventually grind away in that space. I mean... The incentive's there. It's just not enough to be worth the time. And so if you are a very large investment organization, you do have to prioritize. You still have limited resources and time to look for things. So you're going to have thresholds. I'm not going to invest at least at this amount of dollars. And that's where we step in is kind of fill that gap. So you're very much a student of what's going on in the hedge fund world.

43:41What are you seeing in terms of strategies driving costs down and the question of where fees are? They've certainly pulled back from the days of 2 and 20. What's happening in terms of efficiency and cost? There's a bunch of things to talk about there. So first thing I would say is the higher capacity strategies that have become well-known, I think that those costs are going down because there's a lot of people who can implement those strategies. And so you think just simple supply and demand, lots of portfolio managers, you can do them. And so then it's just a competition of who's going to be able to do it most efficiently.

44:14Then there's unique alpha. I think that's harder. And actually the cost of that has gone up over time. It's not gone down. The cost it takes to compete in the space has increased over time. So there's a bifurcation that's been going on. We think that there's still a lot of efficiencies you can carve out of the system that exists now that we're attacking. A lot through technology, a lot through ways of working that can just make the organization more efficient and deliver more net returns to investors. So we've seen some motion towards fees for alpha, not beta. Some people call it pivot fees. There's like a lot of different names for this.

44:50I haven't heard much about that recently. What are your thoughts on where hedge fund fees are going in the future? I'll answer that with a different story that will draw an analogy here. With the rise of indexing, which has been happening for decades now, and thank God for indexing. It's a fantastic invention that has helped a lot of investors. The original thought was, well, as the market goes more and more indexing, and I don't know what the number is, it's probably 70 % is indexed of the invested dollars. then it makes the markets, you know, it's easier to make money because there's less people trying to compete for that.

45:28But that's not what actually happens. What actually happens is it's become more and more difficult to make money because the talent pool is of higher quality now than it used to be that's searching for that alpha. And just like sports, when there's a zero-sum game, right, Right. And it's just it's very small differences between, you know, the number one person and the number five person. What you see is the the rewards and the compensation tends to be a power law, meaning that the very few get get paid a lot. And I see for pure alpha where there's real competition that the the investment talent will actually get paid more and more over time.

46:12It'll get more and more difficult to be that person. Whereas for the common stuff, the well-known things that have higher capacity, I think you're going to see fees keep going down on that side. Michael Mobison calls that the paradox of skill, that the more skillful the players are, whether it's sports, investing, business, the more of a role luck plays, which is really kind of fascinating. You've also written about Portable Alpha. Discuss Portable Alpha. What is that and how can we get some? So I think portable alpha is a great way for investors to get exposure to alternative return streams. What portable alpha is, is mixing a beta like S &P 500 exposure with an alpha stream and really just plopping that alpha stream on top of the S &P 500 return.

46:59So it lets investors get exposure to S &P, which most investors already have, but now exposure to a different type of return stream. Usually people, historically at least, have tried to be the S &P by picking a manager who's trying to pick stocks, overweighting stocks that they like versus the index and underweighting stocks that they don't like. But that comes with a lot of constraints. One is the manager can only overweight and underweight stocks in the index. They can't trade other asset classes. They can't utilize any kind of sophisticated investment techniques to try to beat that benchmark.

47:34Portable Alpha gets rid of all of those constraints. And so what you typically see is portable alpha programs are much better at consistently beating traditional active programs. I like the phrase Corey Hofstein uses for that, return stacking. Is that the same concept as portable alpha? That's right. Yeah, really interesting. Before I get to my favorite questions that I ask all my guests, I just have to throw you a little bit of a curveball. So you're a member of the Yale New Haven Children's Hospital Council. Tell us a little bit about what you do with that. Sure. So just how we got involved, my wife and I, we have the five kids, three of which had severe peanut allergies.

48:18And we were very concerned about that. You know, that's become a rising epidemic within society over time. And we wanted to see if we could solve that, invest in basically research to try to solve this problem. So we work with both Yale and our local hospital to can we fund a research effort and a clinical effort to basically collect data because a lot of the research really needs data. So we work with them. That's how we got originally involved with Yale as an organization. And then they have this council that's focused on children's health issues. And what it is, it's a collection of individuals who are interested in this topic.

48:56We meet typically quarterly. They'll have some of their top researchers from Yale come in and talk about whatever research they're working on and their clinical experiences with children as patients. And that usually generates ideas. Okay, how can we make this more effective? How can we get more funds directed toward this activity? All right, we only have you for a couple of minutes. Let's jump to my favorite questions that we ask all of our guests, starting with, what are you streaming these days? is what's keeping you entertained, either Netflix, podcasts, Amazon, whatever. My wife and I, after going through the litany of all the kids and their issues each day, it's usually very late.

49:35And so we don't get to watch as much TV as you probably would like. There's a lot of great content out there. Lately, we're watching Lioness on Paramount, which is - I just finished season one a few weeks ago and taking a break before season two, but it's fantastic. It's fantastic. Yeah, we've really enjoyed it so far. But I would say - Are you up to season two yet? No, we're three or four episodes in to season one. Brace yourself. You have quite a ride. Okay, great. But in terms of favorite shows, one of my favorites was the remake of Battlestar Galactica, which was a show when I was growing up as a kid.

50:09With terrible special effects in the old one. Yes. And the new one is great, right? That's right. And there's a scene that's actually relevant to our conversation a little bit today. the leader of the Cylons, which is like the robots, is talking with a human. He's one of the fighter pilots. And they're watching a video of one of the battles. And the humans win this battle. But then the Cylon says, this is how we're going to beat you. And the human's like, what do you mean? Because they just watched one of the humans kill one of the robot fighter pilots. and she says, well, every time that we make a mistake and we lose a battle, every single other Cylon learns from that.

50:55And so inevitably we will learn every way that we can avoid dying and we will take you over. And that has a lot to do with how we approach the business on the investing side. Always learn from your mistakes, get the communication out there and constantly improve. If you improve by a few percent a year, that really compounds over time. Well, what does it matter if the AI Cylons eventually are going to kill all of us? It won't make any difference. Alpha is only here until the Cylons beat us in a space battle. Yeah, we view it... That's way off in the distance anyway. We like intelligence augmentation versus artificial intelligence.

51:37IA instead of AI, using these tools to be more effective. That makes a lot of sense. Let's talk about your mentors who helped to shape your career. Well, I would say of all the ones I could think of, Cliff would be the top mentor. And Cliff wasn't the kind of guy who would put his arm around you and say, hey, this is how you do X, Y, and Z, and you should do this differently. He did have several conversations with me like that. Most of his mentorship was through his actions. Cliff's extremely principled, very ethical, and it's a very fortunate thing to be able to be in business with someone like that where you can be successful at business but do it in a very ethical, principled way that's always doing right by the client.

52:21And that's one of the biggest things I've taken away from working with them. Let's talk about books. What are some of your favorites and what are you reading right now? I like history, specifically financial history. The one I'm reading right now is called The World for Sale. It's actually written by a couple of journalists that cover the commodities industry. And it's really about the physical commodity traders and the whole history of that, which is kind of interesting. I love biographies. One particular I liked was the Michael Dell one, Play Nice But Win, where it's kind of chronologically his whole story.

52:54I really connected with the building computers in his dorm and selling them. Obviously, he was much more successful at that than I was. Really interesting. Any chance you read McCullough's Wright Brothers? I have not. Really fascinating. It's unusual to read something that you think, oh, I know that history. And then it's like, no, you have no idea what's going on in that history. And he's just a great writer. Really, really, really interesting. Our final two questions. What sort of advice would you give to a recent college grad interested in a career in either quantitative or investment finance?

53:30I don't know if the advice would be specific to those things, but talk less and listen more, is what I would say. There's a curve. I forget the name of the curve, but it's, you know, you start thinking you know a lot. Dunning-Kruger. Yeah, Dunning-Kruger. That's what it is. Yeah. That is such a true effect. I thought I knew everything. And if I just listened to those around me who knew a lot more, people are trying to help you. more than you realize as a young person. And I should have just listened to more advice. I would have been more successful much more earlier if I had. So here's the funny thing about the Dunning-Kruger curve, and this comes straight from David Dunning.

54:13They did not create the Dunning-Kruger curve. It kind of came from just pop psychology and social media. And then when they went back and tested it, I think the paper was like 99 or 2004, something like that, But when they went back and tested it, it turned out that the Dunning-Kruger curve turned out to be a realistic measurable effect. And it's Mount Stupid, the Valley of Despair, and the Slope of Enlightenment are just sort of the pop terms of it. But it's really, really funny. And our final question, what do you know about the world of investing today? you wish you knew back in the early 90s that would have been helpful to you over those decades?

55:00There's a lot of smart people out there. As smart as you might be, there's a lot to learn from everybody else. Everybody has some insight, some perspective that you don't have. Don't presume that you know what people are thinking. So ask questions and listen. Sounds like good advice for everybody. We have been speaking with Brian Hurst. He's the founder and CIO of Clear Alpha. If you enjoy this conversation, well, be sure and check out any of the 530 we've done over the past 10 years. You can find those at iTunes, Spotify, YouTube, Bloomberg, wherever you find your favorite podcasts. Be sure and check out my latest podcast, at the money short 10 minute conversations with experts about topics that affect your money spending it earning it and most importantly investing it at the money wherever you find your favorite podcasts i would be remiss if i did not thank the crack team that helps us put these conversations together each week sarah livsey is my audio engineer sage bauman is the head of podcasts.

56:10Sean Russo is my researcher. Anna Luke is my producer. I'm Barry Ritholtz. You've been listening to Masters in Business on Bloomberg Radio.

56:39Thank you.