Why Asset Allocators Love Multi-Strategy Hedge Funds

26:51You've got to hire the right people.

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28:29Brokerage services for U.S.-listed registered securities, options and bonds, and a self-directed account are offered by Public Investing, Inc., member FINRA and SIPC. Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com slash disclosures. So listening to you talk on pass-throughs versus traditional fees, the two in 20, I'm kind of wondering why would you ever invest in a pass-through? Because when you describe the downsides, it's like you don't have as much cooperation. Maybe it's harder to move capital around. It seems like the traditional fee structure might be the better choice here.

29:04But tell me why I'm wrong. Well, we've been taking, I mean, this is partially my training, taking the side of the allocator here. And you're right, like superficially at the top level, a pass through seems like a bad idea for the allocator. But there's kind of three people, three entities getting comped here. It's the allocator, there's the manager, and there's the PM. And the thing is, one of the standout features psychologically of most PMs is they all think they're really good. That's how you become a PM. You become ambitious. You press yourself to test yourself against the market. A pass-through manager will give you the max compensation if you're a good PM, right?

29:42And at the end of the day, what we're describing is an industry that relies on PMs to do good work and who are really smart. And if you have a situation where they're going to get paid in a particular entity more than another sort, they will gravitate towards that. So the answer to your question is if allocators had their way, they probably wouldn't want to invest in pass-throughs. But the fact is that they don't have a choice. And pass-throughs are, you know, the other thing to remember is pass-throughs are good for PMs. But the interesting thing, and people do forget about this, is in a pass-through situation in a pod shop, the PM is getting paid from their own P &L.

30:19The manager themselves is fully aligned with the investor, with the allocator, because they're only getting paid off the netted of all the pass-throughs. They're paying off the same P &L at the top line as the investor. So there is somebody, and I mean, people do talk about how much they make and whatever. It's a fantastic, it's like, I've heard it described as the worst, best job in the world. But it's an incredible thing of coordination and getting people together. But they're actually incentivized and aligned with an allocator. And to give them their due, they do their best to do that because they are conscious of keeping costs under control because that's their profit margin that's seeding into.

30:56I mean, the other thing is, which is kind of scary for allocators, is the extra layer of fees, right? and it does cost money. And fundamentally speaking, the other thing that comp is driving in that case is risk, right? They're driving leverage. We've done simulations and a pass-through manager has to be around one third more levered than the two layer fees, two and 20 manager. I mean, they have to be because they have to make more money to pay that extra cash out. And it costs real money to do that. And, you know, in one sense, price is what you pay, value is what you get. returns have been really good because of the pass-through manager has been a really effective business model investing side.

31:36But yeah, I mean, allocators do complain about the cost. Something I'm curious about with the very traditional hedge fund model, which you described very good articulation. If I'm an institutional allocator, I'm diversified. Therefore, I want my allocations to take max risk. The individual hedge fund manager might not want to take max risk because it's their whole career and name on the line. What is actually the expectation in the sort of traditional hedge fund model for like how much of the manager's net worth is in the fund and how do you establish that? And by the way, if I were a hedge fund manager who'd done really well, I would buy a lot of mansions and yachts and stuff so that if my fund ever went to zero, I still would have a lot of wealth.

32:22Oh, you've thought this through, Joe. Yeah. Mansions where in particular? Miami, Aspen, the Gulf States, New York City. Anyway, but like, how do they like, how do you how do they actually establish that the manager is fully aligned with the performance of their fund? So that is a really, really good question because opinions really vary there. Right. And the standard answer to that question is the majority of the manager's liquid net worth. and you can define that whichever way you want. Is there a way to audit there? I mean, there's - I say, hey, look, I have it all in my fund. You can, you can ask the admin.

33:02The manager can authorize the administrator of the fund to disclose their investment in the fund to you if you ask them nicely. They don't know that I have, they wouldn't know if I had a billion dollars in Bitcoin on a private wallet that's not in any key. I'm just saying, I would, when I hear this, I saw this in your notes. When I hear this, my first mind goes to, how can I pocket net worth in places that aren't easily visible and so I'm not fully exposed to my own fund? Sorry. Look, I mean, there's a bigger question there. Okay. And which you mentioned at the start of your question before you went on about the nice mansion in Aspen, which is kind of distracting me right now.

33:40But to be clear, the fact is that if you have all your money in a fund, you're kind of going to mind it differently. Yeah. Right? Yeah. And if I'm an investor who's got a hundred of funds like that, I don't want, yeah. Yeah, you're going to under-risk it relative to what I want as an investor. And so it's a real dance, right? Again, it goes back to the character of the person you're hiring. Yeah. Which we talked about earlier on about the pod shop with a similar scenario. Yeah. It really depends on how you want to risk manage your investments as an allocator, right? Because at the end of the day, when you're asking a manager to put their own capital in a fund, you're assigning them a certain role as a risk manager.

34:18because it, and you have to assess, honestly, my answer is it really depends on the person who I'm dealing with and the sort of person who I think we're dealing with. Right. If I think it's somebody who is just really professional and good, I'm not so sure that having all their money in the fund is necessary. You know, if I think it's somebody where. And they seed other funds too, you know, big fund managers seed. They do. Yeah. I mean, I used to see it at my former job, you know, and it was a real issue because you did have people who, you know, they had made decent money but like what we really wanted to see at the time at pamco was people putting their money into the business you know paying for bloomberg paying for office space you know that over over putting money in the fund because that was commitment to the business oh interesting right i mean that's something that were you know we were comfortable more come as comfortable with them putting working capital into a functioning business interesting then we then maybe putting more an extra 500 000 a million two million three million dollars into a fund very interesting so So much of what you're describing, it sounds very, very granular, like the idea of looking at individual talent to see how they operate, looking at something like culture, which tends to be difficult to define.

35:28If I'm an allocator, how much transparency or how much information am I actually getting from one of these funds? And I realize allocators will hire your company, Alborn, to actually do a lot of this due diligence for them. But if Alborn was out of the picture, what would I be seeing if I'm a potential allocator? So that's a long answer to that question. And it really does depend on if you're a certain size of an allocator. There's kind of the fast lane. So if I'm PIMCO or something. If you get in the executive lounge, you know, you'll get treated more, you know, get more access. And there's nothing wrong with that because simply these people have limited time, you know, and somebody who's going to be a larger client will get more in almost any line of business.

36:13You know, in terms of access, it does vary. I think, you know, if I, you know, speaking in allocator's shoes, you know, basic stuff is regular meetings, good substantial risk reports helping me understand where and how risks are placed, you know, updates when necessary. And then, you know, just it's really, it is granular. Multi-strategies are a combination of both zooming out and taking the big picture. but we talked about what comp means in the global scale and how it's all that. But it's also super, super granular. So understanding, you really want to understand like where their real competency is at the multi-strategy.

36:48Because many places start off with a particular kind of thing they're good at, equities. Yeah. Right? You know, at the end of the day, most multi-strategies make most of their money from kind of, I would call it equity alpha, for lack of a better word, which can include traditional long-straw equity, quant equities, index rebout. We've heard about that a couple of times, you know, all this sort of stuff. That's kind of equity alpha. Then you have other ones who have more focus on kind of fixed income and credit, you know, and you've got to understand what you're getting. And I mean, then you've got to think about, given what I think that my heuristic or my mental map of what these guys are, does each incremental change what they do?

37:25Does that make sense? Because, you know, I mean, one of the things I like to think about is making sure that the stories are aligned. Very simple stuff, right? Let's say I'm a pod shop manager. You're an alligator in here. and I go on, you know, you don't ask about comp structure. Well, my PMs, you know, we put them in a room, we give them Bloomberg, we give them all the facilities they need. We charge them for that and they just get paid on their own P &L. Yeah. Oh, okay. You say, oh, fine, good. And then you say, okay, well, talk to me about, you know, what sort of culture you have. Oh, yeah.

37:54Well, actually, you know, we also, you know, we have a real cooperative culture. PMs love it here. You know, they all get back massages and we all work together as a cross-functional team as well, you know, and you're kind of going, answer one. Yeah. And answer two don't make sense together. Yeah. Right. And you see this in all sorts of subtle ways, you know, and the thing is that what's happened is that people have, you know, the successful funds are the ones who have answered, made answer one and answer two line up together, you know, in whichever way it needs to be. They've worked on ways that make sense that they're kind of, I hate to say, but like a narrative alignment and how they do things.

38:29They know what they're good at. You know, like what, for example, you don't have somebody who's really, really got an equities background. to suddenly decide to hire some, you know, rock star and allocate 40 % into commodities. You know, that would be kind of a weird thing. Well, so I know you're not going to like name any specific names. I will name some names, but you don't have to talk about them directly. You know, like I mentioned, someone like Ken Griffin or an Izzy Englander at Millennium. When you look at the managers who have done really well in this space, what are they good at? They are good at, what I said, kind of bringing alignment.

39:10Finding that alignment. Finding that alignment. Solving for alignment. Solving for kind of the business issues, the risk issues, the investment issues, and the personnel issues. And making sure that they all work together. You know? The really successful people are just, not that they are in it for the money, but now they're in it for the competition to improve. Because, like I said, it's the best worst job in the world, you know? I would like to try it out at least for a little bit, see how good it is. I have a question. Part of the appeal of any multi-strategy hedge fund is the internal diversification, obviously, whether we're talking about the 2 in 20 or whether we're talking about the pure pod model.

39:47You have these periods where one trade more or less works out very well for a long time. In the 2010s, it was the disinflationary trade, which represented in rates, and it was the tech trade or various flavors of that. What do you see when you do due diligence on a fund? What do you look for? Because I would just think, yeah, here's a bunch of people, but you all want to make money, So you all put on the same trade in different clothing, right? And there's different ways to play the same trade. How do the good funds actually establish diversification?

40:25So actually, April is a really good example of diversification at work and what it means for how funds work. And I'm going to loosely describe April, very loosely. And I'm sure somebody in your audience will go, he's completely wrong. But loosely, April was mostly an equity story, right? And what we had, what we saw was equity-only focus managers had a much tougher time of it than the diversified managers. Okay. So diversified, I mean, cross-cermodities, rates, converts, other stuff. And why is that important? Because last year, one of the biggest trades that worked was equities. Right. And so the way you stay diversified is really discipline.

41:06Right. And, you know, in the context of what you're trying to do, one of the interesting things about running simulations around multistrats, right, is you actually don't need to have such great PMs or great trades to have a really good multistrat if you risk manage it right. Okay. If you actually have a set of people who are very lowly correlated with each other and you put them together, you lever them up, you can have a very good business. So to your question is like, the answer is you got to be disciplined. You got to have, like, you put the right amount of risk into your 2010 distance inflationary trade, put the right amount of risk into, you know, fundamental equity market neutral last year, but you make sure that you're not over the limit, right?

41:46And you stay disciplined so that - But if our equity market neutral, I would still find a way to make it long tech and disguise that trade. Oh, people totally do. Yeah. I mean, look, we haven't even gotten into factor controls and stuff like that and so on and so forth. Look, the fact is that, And there's multiple answers to that question across how multistrategies have implemented this in terms of what they're willing to take in terms of factor risk or sector risk and stuff like that. But when you get down to it, look, the job of an investor, any investor, is to take risk in the way they're supposed to.

42:19And multistrategy funds, they take risk. You know, there's no getting around that. Key is how you take it, how disciplined you stay with it, the quality of the people, the quality of the structure around that. and just, you know, sometimes some luck as well. Just on the risk management side, it sounds like a lot depends on historical correlations when it comes to diversification. And what we've seen in recent years and in April is some of those historic correlations breaking down. So for instance, bonds not being a good hedge for equities or more recently the dollar selling off at the same time that bonds were selling off.

42:56How are people managing or judging that correlation risk? Because that seems to be a potential area of weakness for multi-strats. It's a weakness for everybody. Potential area of weakness for everybody. I think, look, management of correlation is super fundamental to management of risk in the context of any multi-strategy hedge fund. There's tremendous benefits to keeping your correlation low between your strategies in terms of risk management, in terms of how much you can lever, in terms of everything. When I look at managers, when I test managers, when I simulate managers, I look at kind of two regimes, low and high correlation.

43:31And everything that works in low punishes you in high correlation, right? For example, when you're creating a diversified portfolio of really cool trades that have nothing to do with each other is great when it works. In a high correlation environment, it's a nightmare because it's things you've never heard of blowing up. Because, I mean, there's a limited amount of things any one person can know, right? So every choice you make at a low correlation environment will come back to bite you in a high correlation environment. Correlations between asset classes is a fundamental part of that. But the critical thing around that is, and this is one of my managers said this, it's like when you're sufficiently diversified, each individual line item you add makes no difference to the portfolio risk or anything like that.

44:13except what you're actually looking to allocate when you're at that diversified is how much of a loss you can make in that high correlation environment, how much of a loss you're willing to bear. And so if that individual component is something that's additive to that loss or makes it worse, that's where you judge it, right? When you're sufficiently diversified. So you try and insulate yourself from breakdowns and correlation by having a budget for that breakdown and correlation and making sure that your individual components, you know what each individual component of a portfolio is going to do for that.

44:42and if you do that then you're kind of that's how you kind of figure that one out look you can buy hedges as well and people do explicitly do tail hedging to provide kind of return and cash in those sorts of scenarios but allocating that tail risk especially in a pod shop because they're more diversified is probably the most important job that these guys have one of the things that i'm interested in you know there's still new multi-strats being launched a lot of them continue to make a lot of money, but there has to be some limit to the alpha generating capacity of these vehicles, I would think.

45:18And I'm trying to wrap around my head about what happened as more and more funds launch and what is the capacity. And based on this conversation, if I had to guess about what degrades alpha over time, it would be something to do with compensation. We're just like all the money accrues at the PM level because there's such competition with more. But talk to us about like, how you would A, articulate the source of alpha and how much can realistically be captured as more and more people and more and more money flows into this space. Okay, so articulating a source of alpha, that's probably one of the biggest questions there is in investing for hedge funds.

45:57Can I come up with a metric? I probably could in terms of just volatility and markets extract, you know, alpha extraction from that. You know, I mean, for me, the kind of critical things in terms of understanding what alpha is, is most of the time in most markets, there is a large number of people with different mandates, different things going on in their head, different things going on in their institutions. As long as there's a sufficient ecosystem of time horizons, capital constraints, there's always going to be alpha. And the interesting thing about certain markets, for example, is like alpha, and this may sound a little bit philosophical, alpha can be something other than money.

46:36For example, if you take a simple tail hedging situation, buying puts on the S &P, right, they're notoriously expensive, right? But the alpha that the people who buy puts get is kind of the alpha of a peace of mind for the rest of their portfolio, right? Right. So, I mean, if you're a hard edge to hedge fund, you're monetizing the alpha by doing a dispersion trade. But like for people who are like feel they can sleep at night by buying puts, that's fine. They're taking their alpha in kind of non-manusory form. Now, I said that's philosophical. In other cases, you know, the hedge fund space, there's a push and a pull going on here.

47:11Right. And so you talk about multi-strategies, hedge funds, but they're not the only sort of hedge funds. There's a whole set of other hedge funds doing other things. And so, you know, if you just, what's been happening, and that's why we're talking about multi-strategy hedge funds is, broadly speaking, hedge fund investing is more or less the same size for the past couple of years. But this share of multi-strategies have gone up because, like, as I said, they kind of offer a pretty good deal to a PM. You know, they take away all the business risk that they have to deal with. They don't have to talk to me.

47:39You know, they just get to invest in trade. We like talking to you. Thank you. But, you know, they take away all that sort of risk. And so the PMs, they kind of have a different, maybe better life, depending on what their admissions are and stuff. And as I said, for investors, the underlying risk taking inside of a multistrat makes for a better kind of return level at the top level. You know, I think this will reverse, you know, over time. But like for the moment, like multistrats and you asked about how big individual multistrats can get as well, which is an interesting question. Empirically, cap is around 50 to 70 billion dollars right now.

48:12You know, whether that's liquidity markets, whether that's share of Wall Street's bank's credit book. book. Oh, yeah. You know, that's always just organizational size because, you know, they're tired to manage, you know, hundreds of PMs, right? Physically and mathematically different to do that. Is prime brokerage a factor as well? Because I imagine, you know, if you have a multistrat that suddenly becomes as big as JP Morgan or something, that's unrealistic. But just as an extreme example, I can't imagine the prime brokers are going to be OK with that. With what exactly? With the size and the risk of a giant multi, of having a relationship with a giant multi-strat.

48:52They would not love it because, you know, it's this famous story of if you owe$10 to the bank, it's your problem. Yeah. A billion dollars to the bank, it's their problem. So, you know, banks across the world avoid, try to avoid having customers so large that it becomes their problem. So yes, the answer is yes. Ronan Cosgrave, thank you so much for coming on All Thoughts and explaining to us why comp is important. That was fantastic. Come back on the podcast again for a further conversation. But that was great. Thank you, guys.

49:26Joe,

49:35that was fun. That was great. Yeah, I like digging into the business model of these things. One thing I hadn't come to appreciate is the idea of how difficult it might be to actually move around capital because no one wants to be firing PMs that you fought like tooth and nail to actually hire in a competitive environment. I mean, so this gets to something that actually I thought about after we did that recent episode with Scott Bach on boutique investment banks, which is the idea of where does franchise value come in in a talent driven business? this. In boutique investment banking, there's another area where it's like, okay, you build this talent, but is there any franchise value external to that?

50:18And so it's really interesting to hear Ronan talk about at any hedge fund, not just the degree to which the manager has actual money tied to the investments in the space, but to which they're invested in the business as a business as opposed to just the fund. I thought that was super fantastic. Yeah. And also like Like the idea of looking at overhead spending as like an indication of how much people care about the business. Yeah. I hadn't thought of that. You know, I would like to be in this space one day. That's never going to happen for obvious reasons. But it's very fun thinking about ways in which depending on what seat we have, we're gaming the system.

50:57So it's like if I'm at the manager level, I'm thinking about how I can have personal wealth that is visible to me but is not visible. I love that your mind immediately goes to gaming the system. Is not visible to the LPs. I think about how if I were at the PM level, I was like, yeah, of course I'm taking a market neutral long short book. But I'm really just finding a closet way to go long NVIDIA during the AI bull market. It does feel, though, that like part of the entire game is here you have these parameters and risk constraints and so forth. And this cat and mouse game between those who want to essentially find a way out of the constraints and those who want to put them back in the box.

51:39Yeah, that seems to be a fundamental tension, although I imagine it exists, you know, in some other funds as well. And I just like the fact that all this bonus money is the business itself. I think that's a really important idea. When you hear about bonuses, et cetera, this is not just like someone getting their Christmas bonus. This is the business itself. This is the business. Shall we leave it there? Let's leave it there. This has been another episode of the Odd Lots 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, Carmen Rodriguez at Carmen Armand, Dashiell Bennett at Dashpot, and Kale Brooks at Kale Brooks.

52:16For more Odd Lots content, go to Bloomberg.com slash Odd Lots. We have a daily newsletter and all of our episodes. And you can chat about all of these topics 24-7 in our Discord, discord.gg. And if you enjoy Odd Lots, if you like it when we talk about why bonuses are the business, then please leave us a positive review on your favorite podcast platform. And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is find the Bloomberg channel on Apple Podcasts and follow the instructions there. Thanks for listening.

52:52Thank you. Thank you.

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