How to Succeed at Multi-Strategy Hedge Funds

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1:26Hello and welcome to another episode of the Odd Thoughts podcast. I'm Traci Allaway. And I'm Joe Weisenthal. Joe, I know we did one episode on pod shops. Yeah. On multi-strategy hedge funds. but it was primarily focused on their impact on the market. And I have to say, I still came away from that conversation sort of wondering if I worked at a pod shop, what is it exactly that I would be doing all day? I would love to know the exact same thing. I mean, like, I guess I have this like very vague sense of sort of, they have a bunch of people all focused on their specific areas and the sort of average out and they net out a bunch of stuff and it's capital efficient and, you know, it's like market neutral in theory and et cetera.

2:15But beyond that, like, I still don't really like understand. The only thing I know is like they've done really well and many people are launching more of them. Yes, they seem to be all the rage. They seem to be where everyone kind of wants to go in the quantitative finance space, at least. Everyone's sort of aiming for these big names, you know, places like Citadel, Millennium, maybe. Yeah. But my question is, like, why? Is it just that they're minting money? They're expected to continue minting money in the future? Or is there something that's like fundamentally intriguing and attractive about working in that space that means lots of people want to get in?

2:53I mean, I think that could be two ways of saying the same thing. If they're minting money, then that probably is fundamentally attractive to people in that space. But I do think like backing up the question is like what we know is that many funds, including apparently even like B tier or C tier funds have done like very well. So I'm just like curious, like how and why? And then, yeah, to the question of like, what does it take to succeed in them? Or who is the type of person who can succeed in this environment? All right. Well, I'm glad you put it that way, because today we're going to be speaking with someone who has done exactly that, succeeded in this particular environment.

3:30We have the perfect guest. We're going to be speaking with Giuseppe Pagliologo, a.k.a. Gappy. He describes himself as a constant gardener, someone who's on gardening leave quite a lot. He is also the author of Advanced Portfolio Management, a quant's guide for fundamental investors. And I have to say, it is one of the funniest books that I've read in quant finance. I can't say it's the funniest because I did read My Life as a Quant from Emanuel Derman, but it's definitely up there. And Joe, I know you enjoyed it, too. I did. You know, I, like, skipped over all the numbers and equations. You just looked at the jokes.

4:05In Greek letters, but it's very breezily written for what it is. And I did actually, I think maybe I learned a little bit even in my sort of basic reading of it. Extremely well written. I'm extremely excited about this conversation. You know, you mentioned that our guest is the king of gardening leave. If you look in his LinkedIn, it really is many different roles. Well, I also have to say he is the only person I know who has both an alpha and a beta tattoo on his shoulder. Oh, wow. You know, some people do get the alpha symbol, but he has both. So, you know, a well-balanced portfolio of tattoos all around.

4:42The yin and yang. Yeah. So, Gappy, thank you so much for coming on All Thoughts. Hi, Tracy. Hi, Joe. So maybe to begin with, I'm going to let you explain your previous job history, because there is quite a lot. What is it that you've been doing in this industry? I'm not sure. OK, good question. Well, I got into this industry almost accidentally. I was for a few years a researcher in the math department at IBM Research. And then I got a little bit bored. So the only industry you can work in New York other than IBM or tech is finance. So I got into finance almost accidentally. And then, again, there is no major plan to my career choices.

5:28When I was getting bored for some reason, somebody called me and offered me a more interesting job. And so I have been working mostly on the so-called buy side of the industry. So the part of the industry that invests, actively invests and takes risks. So I've worked for Citadel twice for a small hedge fund as a portfolio manager and then Millennium and Hudson River Trading. And I've kind of taken turns between doing quantitative research and risk management. So most recently I was at Hudson River Trading until the beginning of November. I think when people think about like multi-strategy hedge fund or pod shop or whatever, maybe sort of Millennium is the first one that would come to mind for people.

6:12If someone asks you, how does Millennium make money? And they seem to have made a lot of money over the years. What's the answer? Okay. I hope without saying anything that is proprietary. Sure. But I think that… Or like the business model of Millennium. Yeah, I think that what Millennium has excelled at has been the ability to scale up, so to adapt its existing platform to accommodate new strategies and new portfolio managers. And so sometimes, actually, in some of their marketing material, they called it something like an investment operating system. So it's a system that is a firm that is willing to absorb some relatively new strategy and create an environment for that strategy to succeed.

7:01And so because of that, I think they might be having right now the highest number of individual pods, maybe close to 300. Whoa. And hovering around$60 billion of AUM, of assets under management. But I would say what is their superpower is really their ability to scale in number of pods. So you mentioned creating an environment for success there. What does that look like at an organization like that? What are the sort of like conduits that allow trades in that particular organization to be successful? So I would give a sort of idiosyncratic, maybe a story around the rationale for success of platforms.

7:47So I see platforms a little bit like managing an arbitrage or some kind of gap between the single platform, the single manager or the small hedge funds and the fund of funds. So if you are a fund of funds, you do have the scale, but you do not have the ability to observe from a close distance the performance of your vehicles for investment. And let's say that they don't perform well. You have to wait a year in order to take your money back. In the case of a hedge fund platform, you could actually not only observe the performance of PMs, portfolio managers, their skill from a very close distance, but you can also help them perform better.

8:30So you can centralize some of the functions that make them better, you know, capital access, corporate access, risk management. If they perform well, to give them more capital. If they don't perform well, to take capital away from them or let them go. And at the same time, you also solve for two other problems. So one is there is a risk transfer happening because a platform, almost by design, otherwise it's not really a platform, has a pass-through fee structure. That's fundamental for the existence of a platform. That makes really a platform what it is instead of a just multi-manager hedge fund like Dishaw.

9:11So this means that a portfolio manager is not paid with the incentive fee that the hedge fund as a whole receives from the limited partners, but instead the portfolio managers are paid a percentage of their P &L, this payment is passed through directly to the limited partners, to the investors. And this basically transfers the risk directly, basically from the PM into the limited partner. And so this makes the system more robust in a sense, right? And combine this with the diversification across investment styles and the number of PMs, and now you start having a moat around a platform that makes it successful.

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11:24Go 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. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. If an entity has 300 pods and everyone's doing their own thing, etc., why doesn't the return just become the market return?

12:00It seems like one intuition could be that this model wouldn't scale. I mean, I know it does, but one intuition could be that this model wouldn't scale, that the more you add, you over diversify, and then you just end up with whatever, like buy the VTI ETF or something like that. Why doesn't it work out that way? The simplest explanation for this is actually just to look at what a retail investor would hold in their portfolio. So let's say that they are, you know, long Apple and IBM. Okay, they have a little bit of an imperfect version of the market, right? But what makes their skill is how different are the weights of their Apple and IBM holdings compared to the market.

12:44Okay, so you can decompose your performance in your personal account into the sum of, let's say, the market and your idiosyncratic bets into these stocks. Now, what the hedge funds do is they do the same, but they completely eliminate as much as they can their exposure or their investment in the market. So they run purely market neutral and factor neutral portfolios. So there is diversification, but these idiosyncratic bets don't get diversified away into a big market, but they actually become essentially a bunch of independent bets that by the law of large numbers, they tend to have better and better risk adjusted profiles.

13:26So I still see some platform heads describe like the overall tilt as market neutral. What do they mean by that exactly? I mean, they typically run a wide range of strategies. So let's focus because it's more relatable. Let's focus on discretionary long short equities and systematic equities, because everybody knows what the stock is. I love that you think systematic equities is relatable. Yeah, I mean, relatively to, I don't know, treasury basis or selling vol. So they mean that typically they do have a so-called factor model. And a factor model is a little bit like having a market model on steroids.

14:04So you have a market term. So you can see your portfolio as having exposure to the market. So behaving a little bit like a market. And then it's also behaving a little bit like a portfolio that has momentum. OK. And then it also has maybe a tilt in terms of value. The platforms tend to run portfolios that have no market exposure whatsoever. And then they also tend to have controlled exposure in these more exotic factors. How do they know that? I mean, so there's someone up there at the center. There's all 300 pods. The data gets aggregated and sliced in various ways. But what is the job or how do they actually ensure that on net their portfolio managers don't have that market beta exposure?

14:53They typically have, at the very minimum, they will buy some commercial factor model, which is a model of the market, like of your investment universe. how a stock behaves, how can you decompose the performance of the stock in these various systematic or let's call them pervasive market-wide factors and instead idiosyncratic. So you buy them off the shelves. I mean, they're really expensive and they do a job. And so once you've bought them, you create some kind of user-friendly interface so that a portfolio manager can always see how the portfolio looks like at any point in time. It's a little bit like having an x-ray of your body in real time.

15:37You can see, oh, well, my portfolio is a little bit short. The market is a little bit long momentum. Maybe there is some crowding exposure, whatever. And so this is in the hands of the portfolio manager. And then there is another layer on top of that, which is very important, risk management, which ensures that PMs are behaving well, that they're not going out of scope. They're not buying micro stocks or investing in crazy stuff. Or just going along in video. Or along in video, yeah. If their idea is going along in video, probably that's not an ideal portfolio manager. So the other thing I've been wondering is how much visibility are there between the different pods within one shop?

16:23And I mean that, I assume there's a centralized risk management system of some sort that is like netting out positions and trying to make use of capital most efficient. And that's where a lot of the edge comes from. But also, if you're just a trader, pursuing your own strategy, do you know what the guy next to you is doing? Do you have that kind of visibility? Or is the idea to keep everyone sort of intellectually separated so that they're not influenced by each other? Right. That's a good question. So there is no really black and white answer to this, because historically there was a time when platforms had more visibility and more collaboration among pods, or at least pods in the same sector, for example.

17:09But I would say that the historical trend has been more and more to give them the tools to succeed, but not give them the ability to see into each other's portfolios, for example. And the rationale for this is you probably prefer having independent bets to having maybe correlated bets that could be like maybe a little bit more informed. So that's the trade-off. If we talk, maybe we can come up with slightly better ideas. But yeah, I think that the trend is more and more toward, no, you are not seeing what I'm having, what I'm holding. Talk to us more about the risk management component. And again, I don't know very much.

17:48I understand that, you know, stop losses are very tight and you don't get a long leash to lose money. And if you're not doing well, your capital is reduced. If you're doing well, I guess you get more. And if you do more, you get more, et cetera. But how would you describe the essence of risk management at the hedge fund level? So there are maybe two or three core functions that can be described in a qualitative way, but I think pretty comprehensively. And then there is something that is a little bit more esoteric or domain-specific. So let's talk about the general principles. Okay, so you mentioned stop losses.

18:25So this is very important. You know, there are always stop losses, the ones that you know you have and the ones you don't know you have. But everybody has stop losses in life, okay? So those are very important because you could imagine that a PM is a little bit like somebody who's holding a call option and you, you know, the PM who's losing money has kind of an incentive to go for broke maybe sometimes. But a stop loss is effectively a sort of a primitive tail insurance, tail risk management tool on the left tail of a PM. So that's very important. The second principle is sort of self-enforcing, is true diversification.

19:04So this is where you want to have some kind of risk model that tells you what are the hidden bets that kind of overlap and maybe compound at the aggregate level. so that if everybody takes a little bit of factor exposure in the same direction, and then you sum this across 300 PMs, it becomes a big factor exposure. So a risk management organization needs to get that right. The third thing is making sure that people stay in scope. Okay, so it seems trivial, but actually that requires a lot of domain expertise. So understanding the trades, what can go wrong from an operational standpoint, microstructure standpoint.

19:43Is this factor drift risk as well? I would say that scope is more like factor drift or in general strategy drift, not only factor, but whereas being in scope is more of a pure strategy drift or just taking risks that a portfolio manager would be possibly aware of, but that maybe the head of the hedge fund, because he's not an expert in that area, is not so aware of. So the risk manager has to know very well what's going on and alert, talk to the PM, talk to the business head. Can you give us concrete examples from your experience of the kind of things that would set off alarm bells? So is there like, I guess you don't have to give us specific examples, but you know, the kind of thing.

20:35The types of examples. Yeah, the types of examples. that would catch your eye in a risk management position? So we covered a little bit the easy stuff, right? So the easy stuff is people taking too much risk, first of all. It's simple, but we think in terms of dollar volatility. Dollar volatility is a little bit like how much you can make or lose in one year, for example. Value at risk, those kind of calculations. Kind of value at risk, yes. I mean, most people think in terms of all value at risk, too. But OK, choose your risk metric. You want to stay within that. Then factor exposures. Okay, that's also easy.

21:09Concentration. So if you take a megabet in NVIDIA, it has to surface. Okay, so these are relatively simple. There are things that are a little bit more complicated. Like, for example, you take some true arbitrage positions where you think that something is running cheap versus rich in, say, bond versus futures. or you do some kind of funding arbitrage trade where different agents in the investing world have different funding rates for their assets. And those can break, like in a dislocation, they can break. And so the way that typically you manage these things, it's a little bit like in merger ARB.

21:48You give it a max size and you want to make sure that this is correct, that this size is correct and it's monitored. So this is stuff that can go wrong. Do managers, like how much do they, I mean, I'm sure there's sort of, I don't know if it's accidental style drift or, you know, drift is sort of a neutral term. How much does the risk manager have to watch out for, I guess, intentional drift or this isn't working. I know this is not quite my mandate. This is not quite what I was made to trade, but I could sort of justify it this way. Or I just see all these lines up over here going up. I need to, how much of a risk management concern is that?

22:26Okay. I think that in general, the principle should be trust but verify. I would say that the vast majority of portfolio managers are very responsible. And because they are in that role, they have been educated to control their risks, to understand them with occasional screw-ups. And so that's why you need to verify. Got it. Okay. On the opposite side of screw ups. I'm curious how capital gets kind of doled out. And if I'm running a massively profitable, successful trading strategy, do I automatically start being given more money to, you know, play around with? Or is there some amount of discipline here where you don't want people to be bumping up against, you know, sizing positions or additional trading costs and things like that.

23:20Imagine I am the most popular trader, the most successful trader. Also popular. I'm both the most popular trader and most successful trader at Citadel. What is the process for Tracy getting more money to trade? How do I get more popular and successful? Probably not popular. Okay. Assume that you're popular and successful. Okay. So do you get more capital? You do get more capital up to a point. So there are a couple of factors. The first one is there is like a natural limit where somebody can be too successful. And without giving examples, but there are large hedge funds whose daily P &L sometimes at points is driven by a single strategy.

24:02And maybe that's justified, right? But there is a point where the risk could be just too much because the concentration across strategies are... Think of pods as stocks, right? You don't want to have 90 % of your savings in NVIDIA. So, okay, so that's number one. So there is some kind of basic heuristics. Then there is just a natural limit to growth for strategies. Like there is a trade-off because your market impact is very high and so, or there is just a hard size for your strategy. So you cannot scale high frequency. You cannot scale to infinity, even index rebalancing. Or if you're a consumer PM, your costs increase faster than the size of your portfolio.

24:48So your P &L in the absence of costs goes more or less linearly, but your costs grow faster than linearly. So there is a point where you just don't want to grow. All right. On the flip side, let's say Tracy comes in and she is a PM and she has her pod. How long is she likely to last? and what would cause her, what would be the threshold at which she gets fired? I don't have the statistics on the average tenure of a PM. Okay. If I had them, probably I shouldn't say. Well, and also depend a lot on the place. Okay, so how long? I would say that it's like everything in life, right? So like 90 % of everything is of poor quality.

25:37I'm sorry to say, but the same applies to PMs. But this is another beautiful aspect of platforms, by the way. Okay, so let me take a quick picture about this. Because like a beautiful and underappreciated aspect of platforms is that they act like sieves. So you go through basically every possible PM on the market and there is a turnover, let's say, of 20%. So 20 % of PMs more or less are let go or leave every year. But you keep the good ones, right? And so eventually you have a sufficient number of PMs who really can carry, make the business sustainable. And a platform is an instrument for exploration.

26:20Okay, so I'm not saying how long they last or whatever, right? But okay, how good do you need to be? I think that if you have a market neutral sharp ratio, which for those who are not used to this number, basically is a risk adjusted measure of profit. So if you take your P &L and you divide by some measure of risk and you get the Sharpe ratio, if you don't have this kind of market exposure, you call it information ratio. If you have an information ratio of one and you're managing your left tail sufficiently wisely, you can survive. Okay. So, you know, start practicing. Okay. Okay. But on this note, the other thing I wanted to ask you was, you know, we tend to talk about these things, platforms, pod shops, multistrat as like this one big blob basically doing a similar thing.

27:14But my impression is that the culture varies quite substantially across firms. And again, there aren't that many that are doing this, although, as Joe said in the intro, the number is growing. But when we talk about that kind of cultural variation, what do we mean exactly? To an amazing extent, I think that platforms are shaped by the personalities of their founders. So is the Englander as a personality and a personal history? Ken Griffin as a different one, the founders of Hudson River Trading, not a platform, you know, strict to censor, but, you know, to some extent, multi-strategy. And so the cultures are very affected by this.

27:57So if you are a trader like Ken Griffin, it's more likely that the fund that you work in, it's more of a trading as opposed to maybe a pure technology culture. Millennium is very decentralized. Citadel tends to run more like a centralized and efficient organization. So in the words of a hedge fund manager, Citadel is like Singapore. and Millennium is like the United States, right? Singapore, very efficient, efficiently run, technocratic to some extent. And the US is messy and inefficient, but it's very robust. And in a sense, you know, Millennium has these features of robustness, of it's like an organic creature.