There’s a decent chance that multi-strategy hedge funds – the shining stars of the hedge fund firmament — will underperform cash over the next five years. To be clear, we have no special information here – just a tad of experience and a sense of déjà vu. What’s bothering us? More assets, bloated fees and higher rates.
To take a step back, the basic pitch of multi-strats is to offer the Holy Grail of diversification: high returns with no correlation to anything else. Like a 12% CD. To do this, they perform the following investment magic. You give them $1. They then (a) leverage it into $5-10, (b) hire the best and brightest, (c) generate alpha on each dollar, and (d) don’t blow up. That essentially describes the trading arm of a firm like Goldman Sachs in the 1970s and 1980s. Make a 30% return on the $1, take half in compensation. Everyone is happy. Millenium, the multi-strat pioneer, essentially has done this since the 1990s. Today, there are perhaps a dozen big players trying to do the same thing, each with their own nuances. Last year, when stocks and bonds went down, these magicians were worth every penny.
What could go wrong this year?
According to the Financial Times, the multi-strat space now manages $300 billion, double what it was several years ago. Those figures don’t account for leverage, so the gross figure is much, much higher. Yet alpha is scarce and also finite. Hence the general rule in hedge fund land: asset growth is the enemy of performance. To manage that bigger pool of assets, multi-strats go out and hire more teams. Hence, the recent hiring blitz. But this raises a few blindingly obvious questions. Is team number 78 really as good as team number 3? If these guys are so good, where have they been hiding? If they just closed a small hedge fund where they failed to generate alpha at 1/20, are they really likely to do this at triple the fees with more AUM?
A proven recipe for overpaying for just about anything is to have someone else foot the bill. Most multi-strat funds charge clients directly for all those teams. With fierce competition for the “best” teams, prices keep going up, and the hurdle before investors sees alpha does as well. The more they offer, the more you pay. Seriously, which allocator thinks this is a good idea?
The trade of a lifetime was borrowing money when rates were artificially low. Middling investors in real estate, private equity and a dozen other areas look like (rich!) geniuses today. The big question is what happens now that real interest rates have gone up by 300 bps in eighteen months and so too have their borrowing costs. Did half of the fabled 30% pre-fee return just evaporate? Did an expected 15% net return just drop to 5%? Further, it’s going be a bit awkward to explain why you tied up money for five years to earn the same amount on a real CD.
Multi-strat hedge funds have defied critics before. A lot of smart people assumed that one or more would have blown up during the extreme market moves over the past several years. And yet they’ve sailed through these violent market gyrations with nary a scratch. 25 years after Long Term Capital, maybe risk managers really are that much better. Others were certain rising assets would crimp returns, and yet most had a monster 2022. But something doesn’t feel right. The moment rates settled higher, returns came down: the PivotalPath Multi-Strat index returned only 2.4% through July, a bit less than your real CD.
There used to be a running joke about Drexel (yes, I’m that old.) alums: “those bastards always somehow leave the room with other people’s chips.” The recent mad rush to invest in these funds enabled top managers – rapacious capitalists, value maximizers par excellence, as one would hope – to lock up investors for up to a decade. Is it that hard to imagine that we’ll looking back in five years and talking about how everyone made money but clients?