How the Rise of 'Pod Shops' Is Reshaping the Way Markets Trade

27:07So now you are now de-risking that Euro-Pollin position, which then causes everybody else to also de-risk as well. So it's not even like a risk management thing. It's just a structure where everybody is allocating capital in the same way, which means that like an innocuous thing, like, you know, somebody literally coughing at some place causes something to move. And then next thing you know, a whole bunch of people have to unwind the positions. So diversification in investing is generally good and people like it. And one way you can diversify is over time. So it's like, in theory, you know, it's like people buy the S &P every two weeks in their 401k or something like that.

27:47But it sounds like your example is that the pod manager does not have the ability to diversify with time. That as soon as the move goes against them, they don't really have the luxury to say, yeah, well, it's just a brief thing and it'll be back to normal. Like that mechanically, they can't let the position lose for very long. Yeah, I think so. And also the other aspect of that, which you touched upon, is the fact that you're not maximizing long-term returns. You're maximizing returns per unit of time, right? So what it means is, let's say, let's take a different example. Let's say you have a stock.

28:26So any given stock on any random day is just some beta to the S &P, right? It's going to move along with the rest of the market. Unless there's some stock-specific news, it's just going to keep up with that. except that when you get into an event, like you have an earnings release or Apple's Vision Pro is getting released, at that time, now there is actually an event and now you have to take a view on either it's going to go up or down at that point in time, right? So what happens with this sort of pod capital and that being a bigger part of the market is that you now have to basically take a view on this event, which is an earnings release.

29:06Now, if it turns out that all the parts think that the earnings are going to be good and that the earnings actually is not good, now we know that the stock is going to have a massive reaction because everybody will try to get out at the first possible time, right? So you create these sort of mini crashes in equities and in other markets because of the way risk is managed, right? Imagine if I were to sort of look at my position every day and say on every little blip, I'm going to take all my risks down and not only take my risk down, but take other positions I might have also down. And that's going to cause these sort of systemic events, which I think is actually an opportunity.

29:47If you're not playing that game and you're playing a slightly longer term game, then it's a great opportunity.

30:34We'll be right back. the supplier lifecycle, helping you deepen merchant relationships. Start fast, grow strategically, and scale at your pace with a modular toolkit you can flexibly deploy. Discover how at mastercard.com slash commercial acceptance. Support for the show comes from public.com. You're thoughtful about where your money goes. You've got your core holdings, some recurring crypto buys, maybe even a few strategic option plays on the side. The point is you're engaged with your investments, and Public gets that. That's why they built an investing platform for those who take it seriously.

31:09On Public, you can put together a multi-asset portfolio for the long haul. Stocks, bonds, options, crypto, it's all there, plus an industry-leading 3.6 % APY, high-yield cash account. Switch to the platform built for those who take investing seriously. Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market. Paid for by public investing. All investing involves the risk of loss, including loss of principal. Brokered services for U.S. listed registered securities, options and bonds in a self-directed account are offered by Public Investing, Inc., member FINRA and SIPC.

31:45Crypto trading provided by ZeroHash. Complete disclosures available at public.com slash disclosures. So just to hammer this point home, in addition to the sort of short-termism that you just described, there's a sort of reflexivity that's happening here too, where if a position starts to trade against you and everyone gets out at the same time, that makes it worse. But also, if a position is going in your favor, then everyone crowds in, and that gives it momentum, and it sort of exacerbates the up crashes, as Joe would say. Yeah, I think to some extent, that is probably the case. But I would say, we probably have the ETFs to blame for that just because of the way the ETF market is.

32:28And a lot of what is happening now is money flowing into ETFs, which then end up buying whatever is the underlying index of stocks. And then you end up with these stocks that don't have a lot of free flow, right? So you have large inflows. I mean, this is not just a US phenomena. Like you look at what happened in Europe year to date, right? The top five, six stocks in market cap are up like 15%, right? And the same thing in Korea, same thing now. So everywhere in the world, as more money flows into these passive vehicles, I think it generates this effect where people are just buying it, you know, without actually looking at the valuation.

33:08So take NVIDIA. As long as we have new money coming into the S &P 500, NVIDIA stock's going to go up. And until something happens, as earnings comes out or something else changes, This thing sort of drives the momentum effect. The pods, I think, have a little bit to do with it, but I would imagine the typical long short equity pod is sector neutral and market neutral and all kinds of neutral. So basically, they try to neutralize every possible factor that they could lose money against, right? And so that's what they do. I actually think that there might be a new factor that we might have to have, which is the multi-fact, multi-strategy pod factor, right?

33:51Because this is a factor, like if you have a stock in which a lot of multi-strategy pods have a position, you know, that might make that stock behave differently. By the way, Supermicro, I think it was up about six, what did I say? It was like up about$60 on the day when we started the episode. Is it up more? It's up 80, 81 now. So when we see these crazy moves on the upside, it's like, okay, there isn't much free float. There's this sort of uninformed demand from the ETF flows. And then when we see like the crazy moves on the down, it's a lot of pod managers all with the same risk profiles. How quickly do they get fired?

34:25Like in my mind, they're like, oh, they have a bad few weeks or a bad quarter. But what is the reality of like longevity? And how quickly did they just say you're not cutting it? You know, my guess, and this is not, you know, by any way, a scientific, you know, sort of thing is probably, you know, it's not very long. But you'd be surprised that a lot of these fairly large platforms have managers that have been around forever, right? And they all have something in common. One of the things is if you have a very high sharp ratio strategy, so a strategy where, you know, your volatility is small relative to your returns, then you're more likely to survive in this sort of hard environment, right?

35:06Because if you have, you know, your drawdowns are limited and then every once in a while you might have a big blow up, but then, you know, that's just part of the high-sharp ratio game, right? So there's a very nice paper by Jean-Philippe Bouchard that shows that most of these high-sharp ratio strategies often tend to have a negative skew to the P &L profile, which kind of makes sense. Like if you're going to sell S &P options every day, that's going to be a very high-sharp ratio strategy until something happens. And then you lose three, four years with a P &L, right? So I think the longevity of a typical part is not that high.

35:44But you'd be surprised how many of these managers have done extremely well over time because they have this sort of high sharp ratio strategies that they can then survive. Some of this reminds me of the original discussion, like I guess it would have been more than 10 years ago now, but around algorithmic or machine learning trading where like the big discussion point was, OK, you get a news release that comes out. Maybe it's something company specific. Maybe it's something macro, like the latest jobs release, and all the machines react to it. Sometimes they actually are, or at least back then, they would pull back from the market and just wait a little bit.

36:27But the idea was that you kind of get this gap where if you're not a machine or an algorithm, maybe there's an opportunity there in the market. Maybe you can be smarter, I guess, than the machines that are sort of like going on on rote code. Yeah, I think if you think about it, the biggest opportunity is for slightly longer term investors. So if you are, let's say your time horizon is not a month or three months, now this gives you a great opportunity because you obviously get these big drawdowns every few months, right? So in my personal view, I think we have some active ETFs and we think of that as longer term capital.

37:07And we're looking at creating some sort of a drawdown structure where we actually wait for these big drawdowns that are caused by the pods and then use that to actually participate in these moves. And that, again, could be a very interesting way to take advantage of this stuff. But anytime you have an algorithm that decides how capital gets allocated and it's sort of rules-based, you kind of know that it's going to create a problem in the end because the market is sort of a complex machine. So anytime you think you've found like some risk mousetrap, you know, it's probably going to create other issues elsewhere.

37:46This might be a simplistic question, but how do you measure drawdowns? How do you know that those are happening and impacting a particular stock or a factor? So you can kind of look at that on a kind of a micro scale by certain specific assets that are in focus. So for instance, like let's say you're going into an earnings release and you sort of see that the stock missed earnings and then it has a massive reaction and it's a several sigma move. And you'd sort of say like, okay, the company didn't miss earnings this quarter, but the otherwise everything else seems to be fine. It shouldn't be as big a reaction.

38:22And you can kind of look at these reactions from the past when they've missed earnings. And you'd find that, you know, the reactions are much larger now. And then part of that has to do with the fact that a lot of the capital that is deployed, apart from the ETFs, which are passive holders of this stuff, the active management part of it is a lot of these parts and multi-strategy funds. And that creates this sort of behavior, not just in equities, but in other assets as well. Like you'd get a really massive reaction in treasuries for like some random thing. And you'd be like, what has changed? Like the economy hasn't really changed that much.

39:00But because like everybody was one way, now they all have to kind of get out of the way. And that creates like, like take the CPI reaction. I mean, you know, we had a big repricing the front end, which kind of made sense. But you look at the treasury move and you say like, ah, does it really make a big difference in the grand scheme of things? The one-year forward 10-year yields and the five-year yields are about the same. They're about 4%. And so that hasn't really changed. But people's positions had to be unbound. And that creates these sort of large reactions. So one thing I was wondering, just going back to why these types of investment firms seem to have proliferated in recent years.

39:44I mean, to some extent, this was the desired outcome of post 2008 regulation. Again, you make it more expensive to get leverage if you're a bank. If you're a bank, you also can't trade for your own account anymore. And so it all shifts into I kind of hate this term nowadays, but the shadow banking system. And it gets done there. So I guess my question is, how worried should we be about this activity on a systemic basis? And then secondly, could multi-strategy pod shops be hit if we were to see leverage get more expensive? So, for instance, there's a lot of talk right now about the basis trade in treasuries, and maybe regulators are going to start cracking down on that or making it more expensive to use treasury futures, which are basically a source of leverage in that market.

40:39Is that a risk here? I think on the second question, there's definitely a risk that the cost of leverage goes up from a systemic point of view. If banks are financing these trades and if that financing business gets charged more in risk capital, then you would imagine that the traction of some of the parts become less attractive. Because if imagine I have to fund my book at 10 % when risk-free rates are 5%, then I'm less likely to find any good opportunities, right? I mean, I'm still going to find something, but not as much of these RV type stuff. But the other aspect of it is like what they're really serving, I think, which is like one of the positives of the multi-strat funds, is that like unlike a fund of funds where you couldn't net risks together, Here, you're able to net all this exposure, right?

41:34So imagine you have one person long of Tesla and the other person short of Tesla. Now, you as the end investor doesn't have to have these two positions and two different hedge funds. They're all getting netted and you're only getting charged for the net exposure. Cross-margining, basically. Cross-margining, which has been a big challenge. So if you're a single manager fund and let's say you're invested in like 10 different single manager funds, what if five of them are long of Tesla and the other five are short? Now your problem is you're on a net basis kind of flat. You're paying for everyone's leverage.

42:10You paid for everyone's leverage. And so that is like a big advantage, I think, of having this sort of thing. But on the flip side, if you think about it, imagine you have five pods that are long of Tesla and five pods that are short of Tesla, just to take a simple example. and Tesla goes up, now typical multi-strategy investor takes all the netting risk. So historically in a hedge fund, if you invest in a hedge fund and the hedge fund didn't make money, you didn't pay any fees to the manager. But now with the pod structure and the multi-strategy platform, the people who made the money are getting their payouts.

42:50And then the ones that lost money, now you're actually taking the losses. So if you have too much dispersion, that's not necessarily good from an overall perspective. And what about the systemic aspects of all of this? So yes, okay, there are some weird moves in the market and maybe there's more short-termism and we're getting bigger reactions to one-off events or announcements. But is it an issue that we should be worried about? Should regulators be thinking about this? Well, I think the issue is less to do with the day-to-day stuff. it's more to do with these events, right? So I think the risk becomes more material when you go into any sort of event that we're not thinking about.

43:32Like for instance, let's say EMP strike happens and all the grit goes down. Obviously we would be thinking about other things at that point, but just to make an example of something that we're not thinking about, if that were to happen, we could have big systemic unwinds of positions just because of the way risk is managed, right? And this is just natural. If you have a system where there's a lot of leverage and it's being tightly risk managed, you're going to create these unwinds over time. I'm curious about the non-systemic risks to the model. And by that, I mean, there have been a lot of new hedge fund launches over the last several months.

44:12I keep seeing headlines on the Bloomberg, many of them with the multi-strat model. I imagine many people at multi-strategy hedge funds want to be the guy on top rather than the pod with always having to worry about, is there capital being pulled? So they leave and start something new. The returns for several of the existing ones are pretty extraordinary. Last year, I think Citadel's, the Wellington fund, it was up over 15%, like really a pretty solid year. Setting aside systemic events, is there a risk that just like the strategy is no longer as good the more people into it? Because typically that's how it is.

44:45You just think about with investing, Various quant strategies eventually don't work when everyone figures out the abnormality or whatever. What do you think about the long-term prospects of good returns in this space as more people try to do the same thing? I think it's a great question. So I think the smaller you are, the better your advantage is. Because if you go back to what I was saying before, if you have a 100 by 100 long short equity book, you could get out of it immediately, right? If you have a fairly large book, it's nearly impossible to get out. There's no exit liquidity for the trades, right?

45:18So the size is a major factor in terms of how they would perform over time. Now, what does happen is the larger funds tend to have better financing terms because they've been around the longer. And so they've locked up all the funding. And so there is a definite benefit for the size. But from a forward-looking return basis, you're going to be much better served in smaller multi-strategy funds because multi-strategy as a concept is not a bad idea. It's just that the size has become so big. And also think about how these managers are moving around, right? So imagine somebody had a great alpha source, some secret sauce, and they worked at a fund, and now their junior person moved to the fund across the street and starts to do the same thing.

46:03Now, essentially, that's what's happening is most of these strategies are the alpha is kind of decaying, right? Because you have all this migration of people. So you might say you have 50 or 40 multi-strategy funds, but they might all be doing something very similar, right? And so that, I think, is going to mean that overall returns might not be as attractive as they have been in the past. I mean, and some of the multi-strategy funds have been spectacular, right? Like you look at Citadel that you mentioned, they've been phenomenal. Millennium had another good year last year. They've been great.

46:39I mean, so in the past, they've been phenomenal. But on a going forward basis, as this thing gets bigger and bigger, you would imagine that the alpha kind of comes down. You don't have as many people. So if you take a typical multi-strategy fund, the person who starts out, starts out with two, 300 million to manage. So if you have a trillion two of capital, you're going to need 40 ,000 different pods. I mean, not every part is that size. A lot of pods are much bigger. But, you know, you can just think about the number of people that you're going to require and enough orthogonal strategies. And I just don't think there's that many, you know, orthogonal strategies out there.

47:17So this might be getting ahead of ourselves a little bit, but we started out describing the evolution of hedge funds. So going from the two in 20 model to fund of funds and then multi strategy. What's next in the evolution? If there is a risk of overcrowding and alpha decay, as you just described, what's the next big thing on the radar? So I think that this will evolve. You know, it'll take time, obviously, because, you know, you'll need a few years of underperformance before people say like, oh, this doesn't work. But in my mind, the two things I'm betting on is one is obviously anything that takes advantage of this sort of, you know, behavior, right, where you're being risk managed and forced to unwind positions.

48:00So if you can actually have slightly longer term capital, you can actually be the person going and buying the stuff when everybody has to sell. Right. So that's a big opportunity, I think. And then the other one is any sort of long term capital structure like an ETF or any of that sort of stuff. Because what happens there is that an ETF investor is not like looking at it every single day. I mean, although some might be, but most of them are investing for the long term. Right. So if you could sort of manage that sort of money, then you get the ability. to actually sit through all these things. Krishna Kumar, Goose Hollow Capital, thank you so much for coming on AdLock.

48:36That was so good. Thank you. Thanks, guys.

48:51Tracy, I really enjoyed that conversation. There was a lot in there that was interesting to me. I think where I would start was actually maybe with that last answer where it sort of seems like, you know, the one thing that a pod seemingly cannot do is just that sort of like long buy and hold philosophy, right? Like that's the one sort of bread and butter investment strategy that you probably can't do when you're being short term managed like that. So in the end, like the sort of benefits may accrue to those who can just and it's like what every financial advisor says, like, right, like buy the index and like stocks go up and go about the rest of your life.

49:26Yeah, absolutely. That really crystallized that point. The idea of like, it's the time horizon that is different here. And also, you know, the crowding behavior. I was sort of thinking back. Do you remember flows before prose? Yeah, that's your line. Yeah. So the idea there was that, OK, in an environment of low returns sort of post 2008, that it's hard to find, you know, genuine like outperformance. And so the best thing to do is just follow the crowd. And that's how you kind of eke out alpha. And then I'm thinking about it in the context of the multi-strategy firms. And I'm kind of thinking like maybe pros create flows now.

50:04Maybe that's what the multi-strategy firms are doing. Like they're just going in and out on a daily basis. Yeah, it's exactly that. Like I knew that there was a lot of trading volume that came from that. But I don't think I like totally understood why they had to trade. So it's like, why not just, you know, invest in some tech stocks and they probably go up. But if you think it was like, no, you're really like not being paid to just like take a long term view or anything, because the long term is for the end investors. The long term is for the LPs and everyone else. like your job is short-term performance and you sort of like diversify it that way and it benefits the long term there's just a lot of interesting things about there's so much isolating aspects there's also you know like it makes so much sense about like the capital efficiency of pod shops versus the fund of funds which no one's right like all these things like sort of make a lot of sense to me now yeah the other thing i would call out is the leverage point and again this has been going on for sort of a long time.

50:58And again, I would call back to the lack of returns in the post-2008 environment. That's when we saw people start to use a whole host of, well, not start, but using a whole host of interesting derivatives, like CDX index options to bet on corporate credit because you had that general macro environment as well. Things are sort of evolving now, but I take the point, okay, leverage is expensive, particularly if you're a bank. And that's part of the reason we've seen it migrate in some respects to multi-strategy funds. But I am interested to see if that kind of war, the regulatory war on leverage, starts to pick up.

51:36Because we have seen, again, going back to the basis trade and treasury futures, a lot of noises about that. And so, yeah, definitely something to keep an eye on. Yeah, there's a lot there. Also, just that point about like, OK, you know, it used to be that the sort of proprietary trader at the bank could take advantage of some weird dislocation when an investor needs to sell some off the run treasuries and there may not be an obvious buyer for at the moment. You like pocket a little bit of money. Yeah. And how, OK, that balance sheet that was available. Yeah. For those types of trades and how that creates opportunities for these funds and the specialists in these areas to identify those.

52:12Anyway, really interesting conversation. So much in there. Shall we leave it there for now? Let's leave it there. Okay. This has been another episode of the Odd Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our producers, Kerman Rodriguez at Kerman Arman, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks. And thank you to our producer, Moses Onda. For more Odd Lots content, go to bloomberg.com slash oddlots. We have transcripts, a blog, and a newsletter. And you can chat about all of these topics with fellow listeners in the Discord 24-7, one of my favorite places on the internet to hang out, discord.gg.

52:49And if you enjoy OddLots, if you like this particular episode of PodLots, then please leave us a positive review on your favorite podcast platform. And don't forget, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect your Bloomberg account with Apple Podcasts. Thanks for listening.

53:19Thank you.

53:44B2B card payment landscape evolving, large corporations face pressure as buyers increasingly demand to pay invoices by virtual card. For merchant acquiring businesses like yours, this is a high growth opportunity waiting to be unlocked. With MasterCard's adaptive approach to B2B acceptance, you can enhance your infrastructure for high value payments and meet your customers' unique needs. MasterCard offers solutions and support for every step of the supplier lifecycle, helping you deepen merchant relationships. Start fast, grow strategically, and scale at your pace with a modular toolkit you can flexibly deploy.

54:20Discover how at MasterCard.com slash commercialacceptance. We buy insurance for peace of mind, but every year millions of claims are denied. Not because people did anything wrong, but because their policies quietly excluded what happened. Insurers know every detail. Policyholders rarely do. That's why My Policy Advocate exists. For just 27 cents a day, their platform reads your policies and explains where you are vulnerable. They don't sell insurance. They deliver transparency. Before you trust your policy to protect you, let My Policy Advocate tell you what it really says. Go to MyPolicyAdvocate.com.