Are hedge fund pioneers facing the end of a golden era?

As an undergraduate at Harvard University, Ken Griffin had a satellite dish installed on the roof of his dorm room so he could trade convertible bonds, laying the foundations for the launch of his Citadel hedge fund in 1990.

But it wasn’t until the high-profile collapse of hedge fund Long Term Capital Management at the end of that decade that he realised Citadel’s potential, Griffin recalls in an interview. As the financial markets were “turned upside down”, Citadel avoided losses and seized on the opportunity to make money, he says.

“This unlocked a substantial number of doors both in terms of our ability to attract talent and to attract capital.”

Citadel was among the first of the so-called multi-manager funds. Last year, it became the most successful hedge fund manager of all time, according to LCH Investments, which ranks firms based on their dollar gains net of fees across their lifetimes. This followed a record-breaking $16bn profit for Citadel in 2022, a dramatic rebound from the financial crisis in 2008 when it came close to collapse.

The ascent of the firm, which now has $62bn under management, illustrates the rise of the multi-manager model. Over the past five years in particular, it has emerged as the fastest-growing and most profitable corner of the global hedge fund industry. 

But the model is facing a moment of reckoning. It is confronting challenges wrought by capacity constraints, including a ferocious and increasingly expensive talent war. Higher interest rates have increased the risk-free returns available to investors, making outperformance harder to achieve and raising the cost of borrowing. 

Investors have also started to question multi-manager funds’ high fees and demands to lock away cash for years. A recent report by Goldman Sachs, which interviewed 340 investors accounting for over $1tn in assets, pointed to a slight increase in those looking to reduce their exposure to multi-manager platforms. Among the reasons cited were “recent rapid growth, capacity challenges and more muted performance”. 

Their growing heft is also putting them under regulatory scrutiny. The chair of the US Securities and Exchange Commission, Gary Gensler, has called for closer analysis of the potential risk hedge funds pose to financial stability following March’s upheaval in US government bonds, a market in which multi-manager platforms are big players.

“The strategy has become so popular and there is a tremendous amount of leverage [such] that an unwind of multi-strats is likely to resemble the ‘quant quake’ of 2007,” said one large investor. During that episode, a number of quantitative hedge funds faced substantial losses and a mass sell-off of their positions roiled markets. 

Performance so far in 2023 has also struggled to keep up with the past few years, and Griffin acknowledges the purple patch cannot last for ever. “The stories of markets are always stories of cycles and strategies that come and go in terms of popularity,” he says. 

“Clearly right now the multi-strategy managers are very much in vogue. When you’re most popular is probably when you’re reaching the top of the cycle.”

The rise of ‘multi-strategies’

The first generation of hedge funds, run by star managers like George Soros, Julian Robertson and Paul Tudor Jones, made their profits and their reputations by taking big thematic bets. 

In contrast, the multi-manager model relies on specialist traders, overseen by sophisticated risk management technology, and a ruthless approach to hiring and firing by their paymasters. 

Pioneers of the structure include Griffin and Izzy Englander, founder of $60bn firm Millennium Management. Both firms launched more than three decades ago and still account for around two-fifths of assets run by multi-manager platforms.

On their heels came names like Dmitry Balyasny’s $21bn Balyasny Asset Management, Steven Cohen’s Point72 Asset Management, which runs $30.8bn, and $13bn manager Schonfeld Strategic Advisors. Multi-manager is an important subset of the “multi-strategy” hedge fund industry, which combine various strategies under one roof and collectively manage about $670bn, according to eVestment data.

There are only around 40 of such multi-manager platforms globally, according to estimates from prime brokers, running around $300bn or 8 per cent of the hedge fund industry’s overall $4tn under management. But they punch above their weight: as of 2022, Goldman estimated multi-managers account for 27 per cent of the total hedge fund industry’s holdings in US equities, up from 14 per cent since 2014.

They use large amounts of borrowing to magnify their positions and amplify returns: an average of more than five times their assets, the report said, and far more in fixed income. So their shifting presence has a disproportionate impact on global financial markets. 

Since the global financial crisis, this corner of the hedge fund industry has been among the main beneficiaries of the Volcker rule, which restricts banks from trading risky assets on their own account. That shifted such risk-taking to less regulated parts of the financial system. 

The platforms’ pledge to deliver strong risk-adjusted returns with low volatility, regardless of which way the market swings, has resonated with clients like pension funds and sovereign wealth funds.

The march of the platforms has gained further momentum in the past five years. Goldman estimates that between 2018 and 2022, multi-manager assets increased by 150 per cent while the rest of the hedge fund industry grew by just 13 per cent. 

‘Groucho Marx syndrome’

It is a model that many admire but few have been able to successfully emulate, largely because consistent outperformance is needed to cover the substantial — and rising — operating costs. “There’s only so much alpha in the world,” remarks Paul Britton, chief executive of $12bn hedge fund Capstone Investment Advisors, referring to the industry jargon for outperformance. 

“New alpha is not being created at the same speed and that means an investment arms race for both talent and technology.”

For the past decade or so, rising costs and more onerous regulation have made it less appealing to launch a hedge fund, allowing multi-manager platforms to hire managers who might once have struck out on their own. 

The pitch to them is simple: you focus on investing, while the platform takes care of everything else from operations to marketing. The pitch to potential clients is that thanks to their ability to nimbly switch money between different trading strategies, multi-manager funds can deliver strong returns with low volatility while carefully controlling risk. 

The groups vary in the nuts and bolts of their approach but they typically employ between tens and hundreds of autonomous and highly specialist risk-takers in teams or so-called pods.

One veteran of the industry likened these institutions to specialist hospitals: “They want you to be the orthopaedist who just does left knees. And they have a different guy to do right knees.” 

Traders compete for centrally allocated capital. Underperform, and your allocation is likely to be cut or you could face the “quantitative eject seat” — industry slang for getting fired. Outperformers get more assets to manage and payouts in the region of 15 to 22 per cent of their gains, according to market participants. It is a brutally meritocratic set-up that some have dubbed a “meat grinder”. 

The labour intensity of multi-manager hedge funds means that they account for a quarter of the sector’s total headcount despite representing 8 per cent of its assets, according to the Goldman report. They invest millions of dollars each year in technology, systems and data in their pursuit of an edge over rivals. 

This high cost base is enabled by the defining characteristic of their businesses: the “pass-through” expenses model, where instead of an annual management fee the manager passes on all costs to their end investors. 

While the hedge fund industry’s standard levy of 2 per cent of assets as an annual management fee and a 20 per cent cut of any gains as a performance fee has faced downward pressure for years, costs in the pass-through model vary from 3 to 10 per cent of assets each year. That covers everything from office rents, technology and data, salaries, bonuses and even client entertainment. A performance fee of 20-30 per cent of profits is typically charged on top. 

But so long as performance net of these hefty costs remained strong, clients clamoured to get into multi-manager funds, with investor appetite exceeding the top managers’ capacity.

The model “is not scalable”, says Nick Moakes, chief investment officer of the Wellcome Trust, a £37.8bn endowment that allocates to the platforms. He calls it the “Groucho Marx syndrome,” referring to the American comedian who didn’t want to be a member of any club that would admit him. “The [funds] that are good are capacity-constrained,” adds Moakes. “The ones that aren’t . . . you probably don’t want to give your money to.” 

In recent years, Citadel and Millennium have returned billions of dollars to clients and switched into longer-term structures that require investors to commit funds for multiyear periods. The duo, along with Balyasny, have also closed their doors to new allocations.

A new generation of imitators has emerged, but new launches have struggled to make a mark. Michael Gelband, once seen as an heir apparent to Englander at Millennium, launched ExodusPoint Capital Management in 2018 to much fanfare. It remains the largest-ever hedge fund launch, yet its performance has significantly lagged behind that of more established peers.

The high barriers to entry don’t appear to be stopping new challengers, though. Bobby Jain, the former co-chief investment officer of Millennium, is preparing to launch a multi-manager hedge fund next year. 

The war for talent

Capacity is determined by the size of their teams. The Goldman report says multi-manger funds employ as many investment professionals as they do non-investment staff. As one hedge fund chief executive puts it: “These furnaces need fuel.” 

After raiding investment banks for traders, the platforms are now increasingly hiring them from one another, making use of the pass-through expenses model to leave investors with the bill for their increasingly costly talent. 

Sign-on packages of $10mn-$15mn are not uncommon, according to market participants, and guaranteed payouts can stretch into tens of millions of dollars. They often include upfront payments to make up for forgone bonuses and two-year guarantees that are paid out regardless of whether the hire lasts the course. 

Now that risk-free rates are at 5 per cent rather than zero, client return expectations are that much higher

Top executives at investment banks such as Goldman and Morgan Stanley say privately that they can’t compete financially with the platforms, while rivals at traditional hedge funds complain that their hiring sprees are bidding up the cost of talent across the industry.

One chief investment officer says his firm is losing mid-level analysts with no direct fund management experience, lured by one of the big platforms for “ridiculous amounts of money” to run a portfolio. These groups will become “a victim of their hiring policies because they’re hiring mediocrity”, he predicts. 

Chris Milner, chief operating officer at $4bn multi-manager Eisler Capital, says funds are trying to cultivate talent internally, but acknowledges that this “is really only just starting on the platform side”. In the meantime, the hiring bonanza continues and platforms are increasingly asking external fund managers to run money on their behalf — another way to add capacity. Goldman estimates that half of multi-manager firms now allocate to at least some external managers.

While costs increase, the investment performance needed to justify them is becoming more elusive. “Now that risk-free rates are at 5 per cent rather than zero, client return expectations are that much higher,” says James Medeiros, president of Investcorp-Tages, a multi-manager firm.

Ermanno Dal Pont, managing director in prime services at Barclays, says that while the success of the multi-managers is partly due to their cost structure, which allows them to heavily invest in people and infrastructure, it “could be an area of vulnerability.”

“The question is whether the opportunity set in the markets . . . will allow them to generate enough gross return to cover their costs and leave enough juice for investors,” he adds.

Becoming mainstream

Asked how the multi-manager story could play out, the hedge fund investor outlines two scenarios: either “someone gets pummelled . . . or they lose their edge.”

If it is the former, then leverage will come into play. Multi-manager platforms borrow money to invest, boosting their returns and making them lucrative fee generators for lending counterparties such as Goldman Sachs, JPMorgan Chase and Morgan Stanley. 

But borrowing also amplifies losses if trades go wrong. When the highly leveraged LTCM collapsed in 1998, concerns about the effects rippling through the financial system were acute enough for the US Federal Reserve to organise a $3.6bn bailout.

Paul Marshall, co-founder of $63bn hedge fund Marshall Wace, says today’s multi-manager platforms are running much lower leverage than LTCM and tend to be “well managed firms that are highly diversified across strategies”. But not everyone is so relaxed; to the suggestion that hedge funds can manage away the risk of a major blow-up, the head of one of the world’s largest retorts simply: “I have no confidence in that.”

The banks that supply the leverage must also control their own risk levels, and as platforms grow so too do fears that banks will eventually want to limit their exposure. “At some point these platforms become constrained not by positioning size, but by the capacity of their counterparties to absorb their business,” says Milner at Eisler.

The chief executive of one large US bank says that while multi-manager hedge funds are only a small part of its prime brokerage business, “it doesn’t mean [they] couldn’t have a broader effect on leverage elsewhere in the financial system”. 

Mike Monforth, global head of capital advisory at JPMorgan, cites the after-effects of the industry’s rapid expansion. “Managers who have not necessarily employed the best talent, don’t have the right infrastructure in place, are not diversified, or those that haven’t optimised their capital efficiency and allocation regime, are going to struggle,” he says. “That’s where you could see more redemptions or possible closures.”

Another threat is that of “crowded trades”, where what were once lucrative strategies become mainstream and the profits from them moderate.

“If there are too many people doing the same thing, the return gets arbitraged away and you’ll see the performance of the platform funds fading away, rather than some big LTCM blowout,” says Marshall. 

“If crowding does become an issue, I think that things will end with a whimper rather than a bang.”

Additional reporting by Costas Mourselas in London