The Ascendancy of Multi-Manager Hedge Funds and the Systematic Risk Implications

Peas in a Pod: Today's Dominant Market Force

Multi-manager hedge funds (aka pod shops) have continued to dominate asset gathering, performance, talent acquisition trends in the public markets over the last 5 years. Therefore it's becoming increasingly important to understand the dynamics at play in how these players shape market movements and stock prices.

The market, at it's core, is simply a reflection of capital-weighted expectations, with the incremental price setter in today's market now being multi-manager "pods".

MM hedge funds saw their assets under management (AUM) surge by 2.2x over the last 5 years from $143 billion in 2018 to just over $311bn in 2022 according to data collected by Goldman Sachs. This growth rate nearly doubles that of the wider hedge fund community, which saw its assets grow by 1.2x from $3 trillion in 2018 to "just" $3.5 trillion in 2022.

It's reasonable to say that $311bn in AUM is tiny in the context of a $50 trillion dollar US stock market. Yes that's true but not fully accurate. Despite multi-managers' AUM standing at $31 billion today, they command a disproportionately large slice of the daily trading volume on liquid stocks.

Why? Two words: Leverage & turnover.

Most Multi-manager hedge funds are running on average 5x leverage on their equity deployed meaning the actual gross market value or their spending power is closer to $1.5 trillion. Additionally, unlike most long-only or single manager hedge funds that might be looking for investment opportunities over the next 1 to 5 years, pods are fishing in much shorter duration alpha pools - typically turning over their book a good 9 to 12 times a year. The speed at which pod shops turnover their books means they likely represent anywhere between15% to 20% of daily trading volume in liquid US and EU stocks.

The implication here is that even if you're a long-term investor in public markets, today you need to know who you're betting against and how they think. The stock market, like poker, requires you to play the cards and play the players at the table too. Today, multi-managers are the chip leaders at the poker table, and they're betting on the cards you are. To outperform the market today and beat the other players at the poker table, you need to understand the cards (stocks) but also the players (pods). And understanding these dynamics is only getting more crucial considering the potential for a systematic event triggered by a pod blow-up. And it's not just me ring the alarm bell on this one - here's what the big dawg KG thinks about the situation:

The Cascading Consequences of a Pod Explosion

Let’s look through examples into how a blow-up in a pod could have significant market ramifications. Take, for instance, the three biggest multi-manager (MM) funds. Each of these MM funds is likely to have at least 3 to 5 pods or sleaves that are focused exclusively on taking long and short bets on technology stocks. For simplicity, I've assumed each has 3 and that's probably not far off the money.

Here are a few of my assumptions on the core economics of those pods. It's probably fair to assume that the average experienced pod PM might be allocated $300 million to invest in equity capital which grosses up to a book value of $1.5bn after 5x leverage. The way most MM's operate is on very tight risk parameters, which of course they need to do given the magnifying impact of debt on returns. The VaR police will typically give each PM a volatility budget or threshold which they have to adhere to based on their own unique seat (e.g. their experience, strategy, sector etc). For simplicity again, I've assumed that they'll be given enough rope to see a 2% drawdown on their GMV (equivalent to a 10% drawdown on equity) before their forced to take a capital cut. Here I'm assuming they take a 50% capital cut after breaching their volatility budget. That drawdown in dollar terms means that if any of these pods loses $30 million dollars or more, they'll be forced to degross their portfolio (sell long positions and buy short positions).

With hedge fund hotels in the tech sector being common, it's reasonable to assume that 9 tech pods across the 3 MMs might have large long positions representing between 3% and 15% of their portfolio.

With that in mind, imagine a scenario where a high-growth technology stock that is widely held by pod shops takes a beating over earnings, dropping 20% - a plausible occurrence

If you're a long-term investor you might think, so what - it's just these spivvy traders punting on earnings, I'll just ride the wave and buy the dip. However, things can get very spicy when leverage and asset correlation mix.

If even a small number of pods (say 4 out of the 9 pods below) have a large position in the same stock that takes an unexpecting hammering over earnings season, that could easily be enough to trigger a 50% capital cut for those PMs.

From the calculations below you can see that a 20% drop in a pods top holding would alone be enough to trigger a capital cut at 4 out of the 9 pods (breaching the $30 million vol budget substantially in some cases.

KG is right in that one pod in isolation isn't a big deal but a pod blowing up can easily cascade into a market wide systematic event. The combination of high leverage, low liquidity, and high correlation can lead to volatile share prices affecting all public market investors.

In this example, the 4 pods would have to sell off $338 million worth of stock they hold in the technology stock, significantly exceeding the stock's average daily volume and potentially causing a further price drop, forcing even those initially unaffected pods to capitulate. If you assume that particular stock trades around $30m a day, then the gross derisking from 4 pods would represent around 11.3x the daily average! That is a) going to be painful to unload and b) it will happen slowly adding to the pain! We haven't even considered the algo's that will likely start to kick in on those types of derisk events - one can imagine it would only exasperate the speed and magnitude of the decline.

What can investors do in such a scenario? The key is to play both the stock and the players. Understand who holds the stock, who the incremental buyers and sellers are, and what they're focusing on. Delve into the datasets they're analyzing to gain insights into their strategies. Multi-managers and pods are increasingly relying on custom channel checks to get early insights into earnings and positioning.

For long-only managers, this knowledge could be crucial in navigating the market effectively, especially when the next pod faces a blow-up. The landscape is competitive, but by understanding the moves of significant players like multi-managers, investors can better position themselves in this high-stakes environment.